Factchecking a U S Treasury Department assessment of bank health

By Dan Brown
ABA DataBank

A recent brief from the Treasury Department's Office of Financial Research entitled, "Bank Health and Future Commercial Real Estate Losses," perpetuates a dangerous, simplistic and misguided storyline about bank health in the United States. The brief contains key flaws in its analysis and ignores important nuance on specific components of bank health. As ABA has highlighted in several previous DataBank posts (such as "CRE Fears are Overstated " and "Why CMBS is a poor proxy for banks' commercial real estate exposures") commercial real estate is a broad asset class with diversified exposure spread among banks and nonbanks. The conservative underwriting and loss provision practices by banks have put them in an excellent position for any volatility in subsections of the CRE market. Furthermore, with the Federal Reserve likely on the cusp of rate cuts, banks' unrealized losses on securities are set to improve as the Fed moves from restrictive policy to a more neutral rate. Finally, the banking system remains well capitalized, and the overwhelming majority of banks has a low share of uninsured deposits.

1. Bank CRE performance is still strong overall, particularly at small and midsize banks.

One of the key assumptions in the OFR brief is that the CRE asset class will have homogenous performance, and that small banks are at higher risk of CRE losses. (Figure 2 in the OFR brief did not even include multifamily, which is a key component of bank CRE lending.) However, as Figure 1 illustrates, office, which is seen by many as the riskiest subsector in CRE, accounts for only 14 percent of bank CRE portfolios, according to ABA analysis of a sample of bank public filings. And even within that subsector, components like medical office, trophy office space and offices outside central business districts should prove to be relatively resilient.

Next, the OFR brief made the generalized statement that small banks with $1 billion or less in assets tend to have higher CRE loan concentration and that is cause for concern. Small banks have had higher proportional CRE lending numbers for decades because they are critical small business lenders in their local communities (see chart 4.16 in the FDIC Community Banking Study.) However, as Figure 2 below shows, CRE charge-offs for smaller banks are near-zero. This is because smaller banks lack the scale to finance central business district high-rise office buildings and instead are typically lending for smaller properties not in central business districts. While larger bank CRE charge-offs have been increasing, their loan loss provisions increased well in advance of this increase. Furthermore, because larger banks are not as concentrated in CRE lending, they should have the scale to absorb potential CRE losses on subcomponents of the asset class that are experiencing difficulties.

2. Pending rate cuts will alleviate pressures on unrealized losses.

As the rate of inflation has started to approach the Fed's two percent target, market participants are anticipating cuts in interest rates in the coming months. The shelter component of CPI, which is a significant weight on the overall metric, is poised to pull the headline inflation number down over the next several months. As of this writing, traders anticipate an 88 percent chance Fed policymakers will cut in September and a 56 percent chance they will cut an additional 25 basis points in November. Rate cuts will increase the mark-to-market value of securities and improve the unrealized loss position of banks.

3. Most of the banking sector has low shares of uninsured deposits.

Finally, the OFR brief noted concern regarding bank uninsured deposits. Specifically, the brief mentioned the 81 banks that have an uninsured deposit ratio of 50 percent or higher. It should be noted that these banks have highly specialized business models that facilitate key financial transactions for the operation of the modern economy, yet only represent less than 2 percent of the industry. Additionally, the brief identified 54 banks with $187 billion in combined assets that have a CRE concentration above 25 percent and an uninsured deposit ratio of 50 percent or higher. This cohort represents only 1.1 percent of all banks and holds just 0.7 percent of banking industry assets. As mentioned above, these smaller banks typically do not have loans for central business district office buildings and cater to a small niche of the market. The banking industry as a whole has a stable share of uninsured deposits over total deposits, and this share has actually been declining since 2021.

Conclusion

OFR's analysis of bank health misses the mark by relying on broad assumptions to make assessments of individual bank exposures. From unprecedented fiscal stimulus, swift and significant increases in interest rates, and volatility in subcomponents in CRE, banks have clearly illustrated they can handle unpredictable shifts in the economy. While there are concerns with subcomponents of CRE, smaller banks are largely isolated from the riskiest CRE loans, and large banks have the resources to absorb any losses. With the U.S. economy on the cusp of rate cuts, lingering problems related to unrealized losses should abate with falling rates. Finally, the industry as a whole has a modest and declining share of uninsured deposits. These last few years have certainly provided seismic shifts in economic conditions, yet the banking industry has clearly proven itself to be resilient and prepared for whatever may occur on the horizon.

Dan Brown is an economist and senior director on ABA's economic research team.

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