The European Central Bank in Frankfurt am Main
Both the European and the German central banks have been issuing ominous warnings over the last couple of weeks about the dangers posed to the banking system by banks' outstanding exposure to the real estate sector.
The sinking commercial property sector across the eurozone could struggle for years, said the European Central Bank in its twice-yearly Financial Stability Report, posing a threat to both the banks and the investors which have been financing it. The report emphasised the Bank's concerns over a property boom which is now unravelling in countries such as Germany and Sweden.
In the report, written by nine individuals, the Bank said it did NOT fear that the demise of the commercial property sector could itself cause a systemic crisis. The banking system is "well placed" to cope with a deterioration in asset quality, bolstered by its "strong capital and liquidity levels" and buoyant profitability, recently hitting its highest level for more than ten years.
Only 10% of banks' total loan books are attributable to commercial property, with 30% exposed to residential property. Yet falling property prices could nonetheless act as an amplifier in stress situations, warned the Bank, heightening the risk of systemically relevant losses both in the banking sector and in other parts of the financial system - such as insurers and investment funds - which are heavily interlinked with the commercial property sector.
The ECB said the number of commercial property transactions collapsed across the eurozone by 47% in the first half of this year compared to the same period last year. The largest listed landlords in the eurozone - such as Vonovia and LEG Immobilien - are currently trading at a discount of more than 30% to their NAVs, the biggest discount since 2008.
The balance sheets of eurozone banks are indeed showing "early signs of stress" after a rise in loan defaults and late repayments from historic lows. The ECB said that a sample of bank loans to real estate firms would suggest the recent rise in financing costs could cause the share of loans extended to loss-making firms to double to as much as 26%. This could increase to 30% if financing conditions persist for two more years - as markets expect - with firms being required to roll over all maturing loans. Even worse, 53% of loans in the sample would be to loss-making firms if those firms were to simultaneously experience a 20% drop in turnover.
The Bank said: "There are substantial vulnerabilities in this loan book, particularly when considering that it is expected that both higher financing costs and reduced profitability will persist for a number of years. Business models established on the basis of pre-pandemic profitability and low-for-long interest rates may become unviable over the medium term."
Distinction between residential and commercial property
Even if only 10% of bank lending is to the commercial property sector, it is here where the ECB clearly sees the most potential danger. As the COVID pandemic has subsided, most eurozone banks have tightened their lending criteria for residential buyers. But, says the ECB, while ‘most all euro area countries have implemented macro-prudential measures to address residential real estate vulnerabilities, policy action targeting commercial real estate (CRE) has been much more contained.’
‘Very few measures in euro area countries target CRE vulnerabilities, as the complexity of CRE markets and the high number of diverse players make a policy response more difficult to design.’
The report states: ‘While the range of tools applicable at the level of banks is, in principle, identical to that of the residential real estate tool-kit, measures available to investment funds or insurance corporations are scarce.’
‘In addition, data gaps are more substantial than they are for residential and hinder risk assessment. All in all, a comprehensive policy response for CRE markets would require multiple measures to be implemented to target all exposed actors and avoid leakages and would need to take particular care to avoid procyclicality.’
Risks remain at 'elevated levels'
ECB Vice-President Luis de Guindos emphasized in the statement that while there may be a perception of reduced immediate risks to financial stability, they still remain at 'elevated levels'. He pointed to the potential impact of factors such as weakened economic growth, tighter financing conditions, increased loan defaults, and a further downturn in property markets.
De Guindos also highlighted the possibility that an escalation of the conflict in the Middle East could act as a catalyst, triggering a sharp increase in risk aversion in financial markets. This, in turn, could unravel existing vulnerabilities by disrupting energy markets, undermining confidence, slowing down economic growth, and leading to an uptick in inflation.
The ECB outlined three primary challenges, or "headwinds," for banks' profitability. These include heightened funding costs as banks pass on increased rates to depositors, a rise in loan defaults due to economic weakening and higher debt service costs, and the potential for a substantial decrease in lending volumes.
The statement from the ECB also noted concerning trends in default rates on both corporate and retail exposures. It highlighted an increase in the share of loans that are less than 90 days past due but still performing, surpassing the historically low levels observed in 2022.
Probable surge of non-performing loans (NPLs) ahead
The warning signals a probable surge in non-performing loans (NPLs), typically trailing an increase in payment arrears by a few quarters. Despite the eurozone banking sector's NPLs dropping to nearly 2% of total loans from a peak of 7.5% during the region's debt crisis a decade ago, the recent dip in European property markets has contributed to a rise in NPLs in loans to commercial real estate and residential mortgages, albeit from low levels. In Q2, there were net inflows of approximately €2.5bn for commercial real estate loans and €1bn for consumer loans after a prolonged decline.
The ECB cautioned that countries with predominantly variable rates could experience a more pronounced decline in asset quality if the labor market significantly weakened. This would compound the pressure on households due to rising mortgage debt service costs and an increased cost of living.
Deutsche Bundesbank warns lenders to boost NPL provisions
Across town in Frankfurt, at the Bundesbank, Germany's central bank was also issuing a clear warning to Germany's financial firms to boost their provisions for non-performing loans in the face of more corporate insolvencies and mounting credit risks.
Bundesbank vice-president Claudia Buch said that financiers may be well-capitalised now, but rising interest expenditure and weak loan demand are covering up unrealised losses.
“Almost two-thirds of savings banks and credit co-operatives now have unrealised losses throughout their banking book, which comprises loans as well as securities. Life insurers are in a similar situation.”
This means book values are often higher than current market values, so selling securities would result in losses, which could then lead to liquidity shortfalls in times of stress, said Buch.
On the current interest rate climate, she said: “I will say that, actually, the financial sector has so far dealt quite well with this increase in interest rates. At the same time, the full effects are not yet visible, so they haven’t really worked their way through the balance sheets of the banks, and this is why we are cautioning the banks as usual."
“Resilience is really of utmost importance at the current juncture. The banks are highly profitable at the moment, and I think it’s good if they use this profitability to increase their resilience — sufficient capital, sufficient liquidity but also investments into IT to shield against cyber risks.”
But she warned that interest rate expenditure would likely rise in the future, which will compress margins and weigh on earnings. “Our simulations show that if banks had passed on higher interest rates at a similar pace as they had done in the past, their net interest income this year would be €29 billion, or one-third, lower,” she said. Those banks will struggle to offset these higher costs by means of rising loan volumes, given the weak level of corporate demand in a recessionary environment.
