Big Banks Face 11% Default Rate in Commercial Real Estate Test

The U.S. banking system remains broadly stable, but a troubling spike in office loan defaults signals deepening stress in commercial real estate, according to the Federal Reserve’s latest supervision report.

At large banks, the delinquency rate for office loans has surged to 11% – marking a concerning deterioration in what was historically considered stable commercial lending.

The trend is particularly worrying because it comes despite overall banking sector strength. Most institutions report robust capital levels, with over 99% of banks considered “well capitalized” by regulators. Yet the commercial real estate sector has now seen delinquency rates climb to their highest level since 2014.

While large banks have so far borne the brunt of office loan deterioration, warning signs are emerging for smaller institutions. Regional and community banks, which typically hold a higher proportion of their assets in commercial real estate loans, saw increased delinquency rates in the first half of 2024. This could pose a particular challenge as these smaller institutions have less diversified portfolios to offset potential losses.

The commercial real estate concerns extend beyond just office space. The multifamily segment has also “come under some stress,” the Fed reports, citing slowing revenue growth, rising operating costs, and declining valuations for certain properties.

In response to these mounting risks, banks have been building their defenses. Institutions are actively adding to their credit loss reserves to protect against potential loan defaults, particularly in commercial real estate and consumer lending sectors.

The broader context makes these real estate troubles more striking. The banking system’s overall liquidity has stabilized since the turmoil of 2023. Funding risks have generally moderated, with uninsured deposits – a key vulnerability last year – declining to levels last seen in 2019. Bank earnings have rebounded, and capital levels continue to rise.

But the persistent and worsening stress in commercial real estate suggests structural rather than cyclical challenges. The Fed’s response has been to intensify its scrutiny, listing commercial real estate as a key supervisory priority and promising close monitoring of banks with concentrated exposure to office and multifamily lending.

With smaller banks now showing signs of strain and property valuations under pressure, the commercial real estate sector could present a significant test for the banking system’s much-touted resilience in the months ahead.

Consumer credit shows cracks

The banking system faces a second area of vulnerability: consumer lending. While delinquency rates improved slightly in the second quarter of 2024, they remain notably elevated compared to historical levels. Credit card defaults have risen significantly from a year earlier, while auto loan delinquencies hover just below their five-year peak.

This deterioration in consumer credit quality is particularly noteworthy as it comes during a period of otherwise stable banking conditions, suggesting potential stress in household finances even as banks maintain strong capital positions.

Deposit landscape shifts

After the turbulence of 2023, the banking sector has seen a marked shift in its funding structure. Uninsured deposits – a key factor in last year’s banking stress – have continued their steady decline, returning to levels last seen in 2019. This trend suggests a more stable funding environment, though banks’ responses have diverged by size.

Larger institutions have increasingly turned to wholesale funding sources during the first half of 2024, while smaller banks have reduced their reliance on such funding. This divergence highlights the different strategies institutions are employing to manage their funding costs in the current environment.

Earnings show resilience

Despite these challenges, bank earnings have demonstrated resilience. Both return on assets and return on equity improved in the first half of 2024, rebounding from fourth quarter 2023 declines that were partly driven by one-time expenses, including the FDIC special assessment.

Net interest margins stabilized in the second quarter after a slight decline in the first quarter, with smaller banks showing more stable margins than their larger counterparts. This stability in margins, combined with higher noninterest income, has helped support overall profitability.

Supervisory focus intensifies

The Federal Reserve’s report reveals an intensified focus on several key areas of risk. Beyond commercial real estate, supervisors are closely monitoring cybersecurity threats, which remain a high priority given their “increasing and evolving nature.”

For larger institutions, about one-third maintained satisfactory ratings across all components of the Fed’s evaluation system in the first half of 2024. The remaining banks received less-than-satisfactory ratings in at least one component, with governance and controls being a particular area of concern.

Looking ahead

The most recent data from the third quarter of 2024 suggests these trends are continuing. Large banks reported a slight decline in return on equity to 12% from 13% in the previous quarter, while deposit costs continued to rise, albeit at the slowest pace since early 2022.

While the banking system remains fundamentally sound, with strong capital levels and stable liquidity, the persistent stress in commercial real estate and consumer lending segments suggests ongoing challenges. These areas will likely remain key focuses of supervisory attention as the banking sector navigates what appears to be a period of structural change in certain lending markets.