Navigating the Shadows: Systemic Risks in the World of Non-Bank Lending
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
Risks to the System from CRE Exposure
For investors and other stakeholders in the commercial real estate industry, the growing exposure to CRE assets could pose systemic hazards. Among these dangers are:
Asset price fluctuations:
Capitalization rates on commercial properties are nearly universally higher as they exist on the books of lenders than those implied by the current interest rate environment. These must agree with each other in time.
Concentration risk:
The financial system is increasingly vulnerable to negative real estate market developments, such as downturns or regulatory shifts, as more institutions become exposed to potentially toxic CRE assets.
Interconnectedness with non-bank lenders and intermediaries:
As shadow banks take on more responsibilities in the CRE market, the risk of contagion effects where financial shocks can swiftly spread throughout the system is increased by their connections to traditional banks and other financial institutions.
Leverage risk:
Institutions may become more susceptible to losses in the case of a market downturn or other unfavorable events as a result of increased exposure to CRE assets and higher levels of debt.
Regulatory risks:
According to the OCC, banks lending on commercial real estate are subject to capital, risk management, and reporting regulations. Shadow banks` participation in the CRE sector, however, raises questions about potential regulatory vulnerabilities and the capacity of authorities to properly monitor and mitigate systemic risks.
Consequences for Stakeholders and Investors
For investors and other stakeholders in the real estate industry, the possible systemic risks linked to increased CRE exposure are important to consider. Stakeholders can take the following steps to reduce these risks:
Diversification:
To lower their exposure to CRE assets and to lessen the potential effects of unfavorable real estate market developments, investors should diversify their investment portfolios by owning uncorrelated assets.
Improved risk management:
To successfully monitor and manage their CRE exposures, financial institutions should put in place strong risk management procedures that streamline hedging processes.
Regulatory vigilance:
To identify possible systemic risks and take appropriate measures to minimize them, regulators should actively watch the CRE market and the operations of both traditional banks and shadow banks.
Financial stability monitoring:
Central banks and other financial regulators should keep an eye on the CRE market`s potential systemic concerns and the connections between traditional banks and shadow banks, modifying their frameworks and tools for policymaking as necessary.
Cognizance of other systems` impacts:
The UK pension system, for example, follows a Liability-Driven-Investment scheme that attempts to match assets with liabilities to meet the obligations of defined-benefit pension schemes. These schemes have been largely abandoned in the US, in favor of defined-contribution schemes, such as 401(k)s and IRAs, which require no such matching. In September of 2022, the US Federal Reserve was forced to delay its rate hike strategy to spare the UK Gilt (bond), as this wore away the buffer between assets and liabilities as the Bank Of England sought to match the Fed hike-for-hike.
For investors and other stakeholders in the real estate industry, the growing ownership of commercial real estate properties and loan books backed by CRE in the US may pose systemic hazards that cannot be solved through traditional means, as these entities are regulated by different agencies whose requirements can differ in meaningful ways that retard solutions. The CRE market is becoming more and more complex as a result of the growing impact of non-bank lenders and intermediaries, underscoring the necessity for regulators to be vigilant and for financial institutions to adopt better risk management procedures. By managing these risks and keeping a wary eye on the CRE market, regulators could stave off the potential for larger sinkholes to develop in the lending environment.
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