Big Banks Say Increased Capital Requirements, Credit Risk Crackdown Would Push Them Out Of CRE Lending

Anyone hoping for a bank lending comeback to revitalize the commercial real estate debt market got some disappointing news Thursday.

U.S. bank regulators proposed a new set of rules that would impose stricter capital requirements on banks, requiring them to hold more assets for each loan they hand out and preventing them from using their own internal risk models. Though it will be years before a finalized rule takes full effect, it still discourages banks from the behavior that several sectors of CRE had depended on for years.

“The large increases in capital standards will likely stunt macroeconomic growth and reduce banks’ participation as single-family and commercial/multifamily lenders, servicers, and providers of warehouse lines and mortgage servicing rights financing,” Mortgage Bankers Association CEO Bob Broeksmit said in a statement issued immediately after the proposed rules were announced.

Broeksmit’s statement was echoed by the leaders of other trade groups like the American Bankers Association and the Bank Policy Institute, as well as JPMorgan Chase CEO Jamie Dimon. All predicted the new rules would funnel more lending business to nonbank lenders like debt funds backed by private equity.

Less competition for debt deals from banks would mean a higher cost of capital, but not necessarily fewer deals overall, developer Don Peebles said.

“The real estate industry will make the adjustment in terms of cost of capital, and it’ll be more efficient,” said Peebles, founder and CEO of the Peebles Corp. “It will just increase the cost of rent, the price of a condo, etc.”

The new proposal from the Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. would apply to all banks with more than $100B in total assets. There are 99 such banks operating in the U.S., according to an FDIC staff report.

Regulators estimate it would require a 16% increase in capital reserves across those 99, with the largest banks bearing the brunt.

The inspiration for the new standard capital requirements is a set of principles laid out by the international Basel Committee on Banking Supervision in the wake of the Global Financial Crisis, called Basel III. U.S. regulators have been phasing in changes recommended by the committee for years, and this latest round represents the final set, known as the Basel III endgame.

The trio of regulatory bodies will accept public comment on the proposed rules until Nov. 30, with its initial phase-in timeline running from early 2025 to late 2028.

They will be under heavy pressure from banks to weaken the proposed requirements, extend the implementation or both. Lobbying spending from banks had already increased sharply in the weeks leading up to the Thursday announcement, Bloomberg reported.

The outpouring of opposition from industry groups was immediate, but it was more in response to the principles espoused by the regulators than the particulars of the proposed rulemaking document, MBA Senior Vice President of Commercial/Multifamily Mike Flood told Bisnow.

At over 1,000 pages, the document will take weeks for most to pore over.

“What we’re going to find out is, just how bad is it?” Flood said. “Now, the devil’s in the details to find out where the effects will be felt.”

Though lobbying groups went on the offensive straight away, executives at several regional banks declined to comment or didn't respond to requests for comment. 

That may be due to regulators skipping the optional step of sending advance notice of proposed rulemaking ahead of the official notice. The chorus of opposition from banks promises to get louder by November if the document’s details don’t contain any better news than the executive summary, Flood said.

Banks’ reticence to comment on the new proposal may also stem from a wariness to oppose regulation so soon after public confidence in regional banks took a direct hit after Silicon Valley Bank and Signature Bank were taken over by regulators. The Fed also raised its benchmark rate Wednesday for the 11th time since the start of last year.

“Given where we are at in the cycle and the intense market focus on regional banks, I will pass on the interview at this time,” Valley Bank Senior Vice President Jerry Lumpkins said via a spokesperson.

Nonbank lenders began grabbing market share the last time banks had to increase their capital requirements five or six years ago, when CRE valuations were still rising. Once debt funds started offering senior loans as "one-stop shops" rather than supplementing bank financing with mezzanine loans, debt overall became more expensive, even if the funds were easier to work with, Peebles said.

“Normally, bank officers are less knowledgeable about the entrepreneurial real estate space," he said, though he acknowledged that such all-encompassing loans have been more expensive than the total of most senior-mezzanine structures. "Private lenders understand the business reality and the practicality of what’s going on in the marketplace.”

Banks' pullback on lending to commercial real estate has been an undercurrent of the frozen debt markets since interest rates began rising sharply last year.

That was sent into overdrive by SVB’s collapse in March. The bank run that spelled its death knell was prompted by the bank selling billions of dollars in loans at a deep loss to shore up its balance sheet.

The proposed rules are meant to prevent exactly the set of circumstances that doomed SVB, but adjusting to them will require banks with too much capital tied up in property loans to sell that debt, Wharton Equity Partners founder and Chairman Peter Lewis told Bisnow before the rules were released.

“If you’re a bank, you don’t want to necessarily be selling at a loss, and right now, you don’t have to, unless regulators come down on you,” Lewis said in a July 6 phone call.

Well over 500 banks are overexposed to commercial real estate based on regulator models, S&P Global Market Intelligence reported on June 22. But the banking lobby says the Fed, comptroller and FDIC are reacting rashly.

“I’m sure that the perceived overexposure is having a direct impact on this," Flood said. "I strongly encourage regulators to look at MBA’s data to understand where exposures truly are.”

The Federal Reserve was aware enough of what could happen if banks felt pressure to reduce exposure as quickly as possible to issue a letter on June 30. The letter encouraged banks to work with CRE borrowers on extensions and modifications. 

Regulators claim a four-year phase-in starting in 2025 is plenty of time for banks to get in compliance simply by saving a higher share of their profits going forward.

But a regulatory stance of cracking down on banks has an immediate effect, Flood said.

“I bet right now, equity analysts have already started pricing this in and banks have already started pricing this in,” he said. “That’s how this works.”

At the heart of the banking industry’s opposition and the reason capital requirements stand to increase so sharply is the proposal to standardize the calculations for how much capital is required to compensate for credit risk.

Banks are allowed to use their own models for calculating risk. SVB’s collapse demonstrated the downside of such permissiveness, regulators said.

The FDIC has been leery of leaving banks to evaluate the risks of their own bets “because of their lack of transparency and variability of results,” FDIC Chair Martin Gruenberg said in a statement released with the rules proposal.

“The proposed changes would improve the consistency and transparency of capital requirements, and would enhance the ability of supervisors and market participants to make independent assessments of a banking organization’s capital adequacy, individually and relative to its peers.”

SVB’s internal risk modeling didn't sufficiently account for the spike in interest rates last year, not to mention the potential impact it would have on startups and venture capital, on which it disproportionately relied. Signature Bank failed two days after SVB, and First Republic Bank went under in May.

“Recent events demonstrated the effects that stress at a few large, regional banking organizations could have on the stability, public confidence, and trust in the banking system,” acting Comptroller of the Currency Michael Hsu said at the Thursday FDIC board meeting when the new proposal was announced.

Banking groups, Peebles and Lewis all pointed at the stress test conducted by the Fed in late June as proof that the banking industry overall is on solid footing. Considering the thousands of banks in the U.S., the fact that only those three have failed this year — plus a Kansas bank with only $139M in assets that folded Friday — is actually a sign of the banking system's strength, Flood said.

The imposition of external credit risk standards will only compound the actual biggest problem for banks, Flood and Peebles said: the widespread value destruction in the office market. 

“You can set regulations up so banks can be healthy and safe and not do insider transactions, but you cannot set up a regulatory environment that can survive a recession without losses, because there will be losses,” Peebles said.