In the wake of 11 Federal Reserve interest rate hikes since early 2022, analysts who cover banks have warned that higher borrowing costs, while taming inflation that
Indeed,
More pain may lie ahead. About 40% of bankers surveyed by S&P in the second quarter said they expected CRE credit quality to deteriorate over the ensuing 12 months, up from 26% in a first quarter poll.
"It doesn't appear we are entering some kind of era of severe losses, but clearly there are issues with office loans already, and these things tend to take several quarters to play out," said Mike Matousek, head trader at U.S. Global Investors.
So what does this all mean for lenders' balance sheets? In short, banks either write down portions of soured credits or charge them off altogether to remove them from their balance sheets. Charge-offs purge loans in full. In the event of a write-down, a bank removes a portion of the souring credit but keeps the remainder of the loan because there is reason to believe it can recover a certain amount from the borrower.
Charge-offs and write-downs create one-time hits to earnings — the loans written down or charged off effectively amount to expenses that offset revenue and curb net income — but these actions also remove the cost of servicing and trying to collect interest on a bad loan over time, allowing banks to focus on profitable assets.
Given that lending is never risk-free, banks also set aside reserves to cover potential future bad loans. This allowance creates a buffer for lenders to absorb losses.
For example, if a bank makes a $200,000 property loan, it may assume the potential for a 5% loss on the loan, based on historical loss rates, market conditions and comparable loans, among other factors. It would then set aside $10,000, or 5% of the loan, as a reserve against possible losses. The bank records the allowance as an expense upfront — providing a cushion for the future — and the remainder of the loan, $190,000, goes on the balance sheet as an asset capable of earning steady levels of interest income.
To be sure, banks try hard to lend selectively — that is, focus as much of their lending as possible on borrowers most likely to repay in full. In challenging economic periods, banks tend to pull back on lending and grow even more selective. This helps them to avoid high levels of loan losses as well as challenges inherent in managing the process of dealing with troubled credits. But it also comes with consequences. Most community banks, for example, rely on lending income to generate profits. If they make fewer loans, profits can drop.
In the second quarter of 2023, bank lending activity slowed when compared with the year-earlier period, and profits decreased in tandem, according to S&P data.
Lenders remain relatively leery.
Small business loan approval percentages at community and regional banks, for example, hovered around 19% in both July and August, according to the latest Biz2Credit Small Business Lending Index. The figures were far below pre-pandemic levels, when conditions were not affected by elevated inflation and high interest rates. For instance, in February 2019, small banks granted 50% of small business loan requests.
"In recent years, smaller banks became more active in commercial real estate loans and did not see the bottom falling out," said Rohit Arora, CEO of Biz2Credit.
This exposed these lenders to losses that are now beginning to show up in industry data. Developing CRE issues could result in more bank charge-offs and write-downs in coming quarters, observers say. Loan losses "going up from here certainly seems probable enough that everyone who covers the banks is watching closely," Matousek said.
