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<\/a>It’s clear that new rules for how banks build their balances are coming. But we don\u2019t know when they will come or how substantial the changes will be.<\/p>\n\n\n\n
The updates to the Basel III international capital rules, called the Basel III Endgame, were proposed by federal bank regulators\u2014the Office of the Comptroller of the Currency, the FDIC and the Federal Reserve\u2014one year ago. The aim of the new rules is to strengthen the banking system by requiring banks to significantly raise their capital reserves and take other risk-reducing measures. Scheduled to take effect July 1, 2025, the proposal, which includes banks with $100 billion or more in assets, provides a three-year grace period for banks to comply.<\/p>\n\n\n\n
But following harsh pushback from the financial industry and an impact study, Fed Chair Powell in March told Congress he anticipated \u201cbroad and material changes\u201d to the proposal, and he did not rule out reproposing the rules. Last week, he indicated to Congress that the final rules, or the next proposal, could be ready at the beginning of next year. That uncertainty has commercial real estate finance professionals anticipating the worst at a time when liquidity is already strained.<\/p>\n\n\n\n
\u201cThe MBA has been advocating very strongly against that rule because\u00a0it could have a negative impact on commercial and residential mortgages,\u201c explained Stephanie Milner, associate vice president of commercial and multifamily at the Mortgage Bankers Association. \u201cWhen you increase capital requirements for banks, it obviously impacts their appetite for lending overall and the sort of pockets they look to for lending activity.\u201d<\/p>\n\n\n\n
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READ ALSO: <\/strong>Regional Banks Retreat as CRE Loans Mature<\/a><\/p>\n\n\n\n The proposed improvements, like the original Basel III international accord of 2009, are aimed at preventing another financial meltdown like the 2008 GFC. As such, the proposal is estimated to result in an aggregate 16 percent increase in common equity, tier 1 capital requirements for affected bank holding companies, principally the largest and most complex banks, said Washington, D.C.-based David Wessel, senior fellow in economic studies & director at The Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, in a white paper<\/a>.<\/p>\n\n\n\n The effects of the Basel III Endgame on individual banks would vary based on activities and risk profile, but, Wessel noted, most banks currently have enough capital on hand to comply with proposed requirements.<\/p>\n\n\n The Fed\u2019s most recent bank stress test<\/a>, in fact, verified this contention. This annual tool used to measure large banks\u2019 ability to support the economy in a downturn, showed that banks would endure greater losses in 2024 than last year but are well positioned to weather a severe recession and stay above minimum capital requirements.<\/p>\n\n\n\n \u201cPeople like to point to the S&P and that a few of the banks failed last year,\u201d said Milner, \u201cbut No. 1, that didn\u2019t have anything to do with banks being\u00a0adequately capitalized nor (with) their commercial real estate\u00a0holdings, and, No. 2, bank failures are going to happen.\u201d<\/p>\n\n\n\n Critics of the proposal have voiced concerns over the negative impact of higher bank capital standards on availability of capital to lend, lending policies and GDP.\u00a0According to Wessel, Fed Gov. Christopher Waller, who voted against the proposal, is concerned that it would raise the cost of debt by moving lending activities outside the regulated banking system to less regulated lenders.\u00a0<\/p>\n\n\n\n \u201cWith commercial real estate continuing to become more expensive for lenders, banks will continue to exit the space, providing alternative lenders a seat at the table,” noted Meredith Ager, EY principal for strategy and transactions, financial services and real estate, but added that alternative lenders, outside of CMBS, are more costly than banks and often the lender of last resort.<\/p>\n\n\n\n Milner concurred, noting that funds and alternative lenders charge significantly higher interest rates than banks\u201410 percent or more. <\/p>\n\n\n\n While there are other lending sources available, without banks it would be very difficult for the lending community to meet the needs of the commercial real estate industry, suggested San Francisco-based Michael Heagerty, a principal & chief financial officer for Gantry, a mortgage banking firm, pointing out that banks are the largest holders of commercial real estate debt.<\/p>\n\n\n\n Banks represent\u00a0 40 to 45 percent of all commercial real estate\u00a0originations in most years, with the largest banks accounting for about 25 percent\u00a0of originations, while the newly affected banks\u2014$100 to $700 billion of assets\u2014typically originate 30 percent, according to Rebecca Rockey, deputy chief economist & global head of forecasting at Cushman & Wakefield.<\/p>\n\n\n\n \u201cSo we\u2019re talking about up to 55 percent of 40 to 45 percent of the market being most affected by Basel III,\u201d she noted.<\/p>\n\n\n Meanwhile, the commercial real estate debt market is already pressured by higher CRE interest rates<\/a>. \u201dIt\u2019s very, very difficult out there right now, as banks have essentially pulled out of commercial (real estate) lending, particularly in the construction market,\u201d Milner said. \u201cIt’s not that developers can’t get a loan, they just can\u2019t get it at an interest rate that works.\u201d The higher capital standard would further reduce banks\u2019 willingness to loan and tighten lending policies.<\/p>\n\n\n\n High interest rates are by no means the only challenges for commercial real estate.\u00a0\u201dInflation is causing expenses to skyrocket, especially for insurance coverage, which lowers property cash flow and valuations,\u201d Ager said.<\/p>\n\n\n\n \u201cIn addition, office properties are confronting starkly different market conditions resulting from the permanence of postpandemic remote work patterns, which have led to historically high vacancy rates of approximately 20 percent in certain U.S. cities, especially in high-tech locations such as San Francisco and Seattle. This new pattern does not simply affect office. Renters living in expensive downtown submarkets continue to favor areas with lower costs of living, impacting the multifamily space.\u201d<\/p>\n\n\n\n Raising capital reserve levels an estimated 16 percent \u201ccould have a macro-drag effect across all types of loans, as credit availability would tighten,\u201d noted Cliff Stanford, partner at Alston & Bird and leader of the firm’s Bank Regulatory Team.<\/p>\n\n\n\n Heagerty is particularly concerned about the proposal\u2019s impact on affordable housing production. \u201cBanks are an important source of construction loans for affordable housing,\u201d he said. \u201cThe regulators should be finding ways of encouraging lending for affordable housing, rather than further restricting capital flow into those markets.\u201d <\/p>\n\n\n\n Basel III also will put pressure on banks to adopt a more in-depth risk management system, leading to stricter lending standards for CRE loans as banks aim to manage and mitigate their credit-risk exposures. noted Nicole Schmidt, a broker at Built Technologies.<\/p>\n\n\n\n A requirement for banks to factor risks associated with their operational costs into their capital reserve equation would further limit the amount of capital available to loan. Under current rules, only the biggest, most complex banks, offering \u201cbeyond products and services\u201d like financial advisory and investment services, insurance, investment, and wealth management, are required to hold capital against operational risk.<\/p>\n\n\n\n The proposal, however, would extend this rule to more banks, according to Wessel, who mentioned that operational risk in the proposal is measured by a \u201cbusiness indicator\u201d based on the size, complexity, and specifics of a bank\u2019s lending, investing, and financing activities and by its history of operations-related losses.<\/p>\n\n\n Members of the Fed board have been working on proposal revisions that would significantly curtail the capital impact for larger banks. However, regulators are split\u00a0on how to proceed, with the Fed open to a re-proposal and the other two agencies viewing it as an unnecessary step that would delay implementation of the project for months, reported Reuters<\/a>.\u00a0<\/p>\n\n\n\n The re-proposal would require a period for public comment, as Powell told the Senate Banking Committee, “When there are broad, material changes, that has been our practice.”<\/p>\n\n\n\n According to Stanford, \u201cthe entire banking industry is waiting with bated breath for a decision from the Fed as to whether they will finalize the rule as proposed or re-propose the rule.\u201d\u00a0<\/p>\n\n\n\n While regulators have not disclosed details of the proposal\u2019s changes, eight industry executives, who are\u00a0 in regular contact with agencies and regulatory officials, said in an earlier Reuters report<\/a> that\u00a0officials are also expected to scrap or reduce higher risk weights on mortgages to low-income borrowers and on renewable energy tax credits.<\/p>\n\n\n\n There are a couple positives in the current proposal, however, Milner added, noting that the risk weight for statutory multifamily mortgages\u2014those that meet prudent underwriting standards and certain criteria that provide a 50 percent risk-weight exposure\u2014is not changing from what\u2019s currently in place.\u00a0Risk weight refers to a system for classifying loans on assets based on their risk level and potential for loss.\u00a0In this system, each asset\u2019s loan is multiplied by a percentage factor to reflect its risk of loss to the bank<\/p>\n\n\n\n Additionally, Milner said that currently other types of commercial loans generally receive 100 percent risk weight if non-delinquent. The new proposal creates an LTV striation, so that if a loan has a lower LTV, it will get a little bit lower risk weighting than under the current regime.<\/p>\n\n\n\n But, while risk weights on the various types of commercial real estate will remain the same, given the higher regulatory capital on net that banks will need, pricing, spreads over fund costs, or borrower interest rates are likely to go up, Rockey observed.<\/p>\n\n\n \u201cIn that case, other lender types stand to become comparatively more competitive in terms of both debt costs and debt terms, which could help to funnel more loan demand toward alternative lender sources, such as commercial real estate debt funds <\/a>and private lenders that have been amassing significant capital to deploy into this normalized interest rate environment, added Rockey.<\/p>\n\n\n\n She noted that alternative lenders’ share to the commercial real estate debt market has already gone up this year, with debt funds’ share increasing 16 percent year-to-date versus 9.4 percent pre-pandemic, reflecting a dramatic 71 percent increase in market share. Private lenders’ sources also\u00a0are capturing a larger share of the market, vs. pre-pandemic, of 3.6 percent YTD vs. 1.0, respectively.<\/p>\n\n\n\n
\n\n\n\nBusiness without banks<\/h2>\n\n\n\n
Increased risk management<\/h2>\n\n\n\n
What to leave in and what to leave out<\/h2>\n\n\n\n
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