In the midst of economic optimism, 2024 raises red flags for the banking industry, with commercial real estate (CRE) taking center stage. Unlike previous cycles, concerns about CRE have gone mainstream, drawing attention from regulators, media, and investors alike. This time, the pressure demands a unique response from banks.

The Shift: Why This Time Feels Different

Regulators, still recovering from recent bank failures like Silicon Valley Bank and First Republic Bank, are adopting a more aggressive stance. Media coverage and investor scrutiny have intensified, putting CRE concerns in the spotlight. Structural changes post-pandemic, particularly remote work policies impacting the office sector, add to the complexity.

Expanding Concerns: Beyond the Office Sector

Initially concentrated on the office sector, worries now extend to multifamily and other segments. Issues like slowing rent growth, increased apartment supply, and loans from the low-interest rate period of 2021-2022 contribute to the broader apprehension.

Community Banks in the Spotlight: Guilty Until Proven Innocent

For community banks, the challenge lies in combating a "guilty until proven innocent" perception. Despite varying exposures, banks are collectively under scrutiny. Differentiating factors include geography, property types, structure, vintage, and growth timing. Many banks have exposure to office, but that exposure is limited to offices in suburban markets or medical offices with low vacancy rates. But you will have to prove and explain this, as opposed to assuming your stakeholders will automatically recognize this distinction.    

Taking Control of the Narrative: Stress Testing as the Key

To tackle these challenges, banks must take control of the narrative through data and analytics. Stress testing emerges as the ultimate tool, but not a generic one. Stress tests must be comprehensive, running loan-level analyses, differentiating by property type and vintage, and quantifying impacts on capital and loan loss allowance.

Key Components of Effective Stress Testing:

1. Loan-level Analysis: Stress test results should be calculated at the loan-level, but be driven by the unique risk characteristics of each loan. Ideally all loans are stressed for a complete assessment, not just CRE.
2. CECL-Compliant Methodologies: Measure how the allowance would be built if stress materializes.
3. Full P&L and Balance Sheet Impact: Quantify the effects on regulatory capital ratios, cannot just be loan-level or CRE portfolio-only!
4. Handling Multiple Scenarios: Ensure flexibility with diverse stress scenarios, ranging from a 2008-style downturn (such as the CCAR scenario used by large banks) or a early 1980’s stagflation scenario that combines rising rates with a recession.
5. Synthesizing Results: Condense findings into three to five key takeaways and actionable recommendations.

Sensitivity Testing as a Complement to Stress Testing:

Complement stress testing by shocking income levels, interest rates, and property values of individual borrowers. This enables banks to develop proactive strategies for individual borrowers, but is not very useful for strategic and capital planning. Banks should be doing this, but should not mistake it as a stress test because it does not specify a specific scenario (such as a 2008-style crisis).

Preparing for the Worst: Building a War Chest

While preparing for potential challenges, banks can turn crises into opportunities. If stress testing is done properly, it quantifies the amount of capital you need. But any remaining capital is excess capital.

Excess capital, the war chest, becomes a strategic advantage. The best loans are often made during downturns when banks equipped with conviction and excess capital can seize opportunities and gain market share. Be ready just in case!

Conclusion: Defense and Offense in Unpredictable Times

Successfully navigating CRE concerns requires a delicate balance of defense and offense. By implementing robust stress testing, community banks can not only communicate their story and protect themselves, but also position for growth in uncertain times.

Stay prepared, stay proactive.

To schedule a consultative discussion, please reach out to Patti Casaleggio at pcasaleggio@invictusgrp.com