Decoding Banks’ Exposure to the Upcoming Crisis in Commercial Real Estate (A Data-Driven Analysis of Banks - Part 2)

Welcome to another edition of “In the Minds of Our Analysts.”

At System2, we foster a culture of encouraging our team to express their thoughts, investigate, pen down, and share their perspectives on various topics. This series provides a space for our analysts to showcase their insights.

All opinions expressed by System2 employees and their guests are solely their own and do not reflect the opinions of System2. This post is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of System2 may maintain positions in the securities discussed in this post.

Today’s post was written by Aquiba Benarroch, CFA.

Welcome to Part II of this series: A Data-Driven Analysis Using Bank’s Call Reports.

In Part I, we discussed the impact of Fed rate hikes on the banking sector and did a backwards-looking examination of the collapse of First Republic Bank using Call Reports’ data fetched from the FDIC API. We demonstrated how this data can be used to perform an in-depth fundamental analysis of a failed bank.

This is what happened at First Republic Bank:

  1. Depositors started losing confidence in the bank following the failures of Silicon Valley Bank and Signature Bank.

  2. Depositors withdrew a lot of cash in a matter of weeks.

  3. The bank had insufficient cash to cover redemptions, as most deposits were loaned out long-term.

  4. To avoid selling loans at heavy discounts, First Republic borrowed to cover redemptions, and large US banks tried to help by loaning their deposits.

  5. The damage was already done, and JP Morgan eventually acquired the bank.

→ If you want to read the full story, click here.

This second post adopts a forward-looking perspective and focuses on the aggregate exposure of regional and local banks to the Commercial Real Estate industry.

First, we’ll discuss the problems in the Commercial Real Estate (CRE) industry and their implications for banks. Second, we’ll use a variety of metrics to assess the banks’ risk exposure to the industry.

Problems in the CRE industry and implications for banks

In recent months, the Commercial Real Estate (CRE) industry has been a hotbed of discussion and speculation. Various factors, such as rising interest rates, changing work habits, and economic uncertainty, have intensified the scrutiny.

Below are the key risk factors, in my view:

  • Rising interest rates devalue property and deter leasing, increasing default risks for banks issuing CRE loans. Higher interest rates increase the cost of borrowing to buy or refinance property. This reduces the number of willing buyers, driving down real estate prices. Also, existing property owners face higher interest payments, lowering property income and thus its valuation. This makes the asset less attractive, further depressing its market value. Higher interest rates lead to higher financing costs for businesses leasing commercial spaces. This makes leasing less attractive than other cost-cutting options, reducing overall demand. Additionally, tenants may downsize or opt for shorter lease terms, making it harder for commercial real estate companies to secure long-term revenue streams.

  • Work-from-home trends weaken demand for office spaces and other commercial property, adding another layer of risk for banks. Survey data from WFHResearch (thanks, Random Walk!) indicates that employers aim for ~2 WFH days per week, so less office space is needed.

The 'Urban Doom Loop' for Commercial Real Estate - Real Vision (https://www.youtube.com/watch?v=IkTh9R2eB2I)

  • Inadequate risk provisioning could lead to significant losses, damaging earnings and eroding equity capital. If a borrower can't refinance or defaults, the loan turns non-performing. Banks must then set aside reserves to cover potential losses, impacting their earnings. If the default size is large enough and the bank hasn't set aside sufficient reserves, it eats into its equity capital. In extreme cases, like Silicon Valley Bank in 2023, this can wipe out the equity, leaving the bank insolvent. For shareholders, this means a loss of investment.

  • Bank runs are a looming risk if depositors lose faith in a bank's solvency, exacerbating liquidity issues. -Depositor flight, or a "bank run," occurs when customers lose faith in a bank's solvency and rush to withdraw their deposits. When a bank's solvency is questioned, this can trigger a cascade of withdrawals. Banks usually lend out most of the money they receive as deposits and keep only a fraction in reserve. When a bank run happens, the institution may not have enough liquid assets to cover all the withdrawals. This happened at First Republic Bank (as discussed in Part I.)

  • Real-time data analysis, like Call Reports, is crucial for identifying vulnerable banks and mitigating investment risks. By conducting ongoing due diligence and leveraging real-time data, such as Call Reports, investors can identify the banks most susceptible to industry downturns. Proactive portfolio positioning—like reducing exposure to high-risk banks or hedging against sector-wide vulnerabilities—allows investors to mitigate potential losses and capitalize on emerging opportunities.

Assessing banks’ risk exposure to the CRE industry

Call Reports provide a variety of metrics to determine banks’ health. These reports offer a range of metrics useful for assessing a bank's financial condition, including its exposure to specific sectors like commercial real estate (CRE).

In this analysis, we target banks with assets ranging from $250 billion to $10 billion, totaling 130 as of March 31, 2023. These banks predominantly comprise regional and local institutions with sizable CRE loan portfolios.

Given the aggregate perspective of this analysis, we'll leverage histograms to capture the distribution of various key metrics. On the x-axis, we have 'bins' that represent ranges for each key metric we examine, such as loan-to-deposit ratios. The y-axis indicates the number of banks that fall within each bin. This visualization technique allows us to efficiently gauge the distribution of these metrics across the banking sector.

Key conclusions

  1. Regional Banks Are Overexposed: Many regional banks have dangerously high exposure to the CRE industry.

  2. Thin Safety Margins: High loan-to-deposit ratios across numerous banks indicate inadequate liquidity buffers, amplifying systemic risk.

  3. Credit Reserve Shortfall: Existing credit loss allowances are insufficient to cover the heightened risks in the current CRE market landscape.

  4. Red Flags in Loan Repayment: The divergence between low delinquencies and high nonaccruals indicates concealed risks, raising questions about loan portfolio quality.

  5. Inadequate Equity Cushion: A moderate drop in CRE loan values could wipe out their Tier 1 capital for many banks, putting investors at high risk.

In-depth analysis

Heavy CRE loan exposure suggests vulnerability in the regional banking sector.

  • More than 1 in 5 regional banks with assets between $250B and $10B have a high level of loans tied to commercial real estate, making up more than 30% of total assets. This concentration indicates that these banks are at greater risk if the commercial real estate market faces any downturns.

  • Another angle is scrutinizing how loans are distributed within these banks.

  • For 42 banks, a significant chunk—more than 40%—of all their loans are in commercial real estate.

Liability duration mismatch amplifies risk, particularly in banks where loans exceed deposits.

  • Liability duration mismatch can become a serious problem during a bank run, as the bank may not have enough liquidity to cover rapid deposit withdrawals (what happened at First Republic Bank.)

  • Accounting capsule 💼: Liability duration mismatch occurs when the time frame for a bank's loans to be repaid is much longer than when its deposits can be withdrawn.

  • High loan-to-deposit ratios near or exceeding 90% (as occurs in one in three regional banks) indicate banks are operating on a razor-thin liquidity buffer, significantly elevating the risk of insolvency during liquidity crises. Even more alarming, 20 of these banks have total loan values that exceed their deposit values. The risk of bankruptcy skyrockets in these cases.


Insufficient loan reserves and potentially higher delinquencies signal a high risk of significant losses.

  • Credit Loss Allowance acts as a financial buffer against potential loan losses.

  • Current reserve levels may align with historical norms but cannot absorb elevated risks in the CRE landscape.

  • Sub-1.5 % reserves are insufficient in a downturn, jeopardizing the bank's financial stability. Accounting capsule 💼: Credit Loss Allowance is an accounting practice to anticipate and account for loans that might not be paid back. By setting aside these reserves, the bank's financial statements reflect a more accurate picture of its financial health and risks. This also ensures the bank has a buffer to absorb losses, protecting shareholders and depositors. In case of loan defaults, the reserves can cover losses without significantly impacting the bank's operations. If loan losses go beyond reserves, they directly hit the bank's equity capital, weakening its financial position.

Low delinquencies contrast with elevated nonaccrual loans, signalling a disconnect.

  • While fewer borrowers are late on payments, a larger portion are deemed unlikely to repay at all.

  • This divergence is a red flag, indicating that the bank's loan portfolio is riskier than delinquency rates alone suggest.

  • If these nonaccrual loans are written off, the bank's already thin reserves could be wiped out, escalating its risk profile.Accounting capsule 💼: Delinquencies refer to loans where borrowers are late on payments. In a stable environment, a low level of delinquencies, like most banks currently report, indicates good loan performance. Nonaccrual loans are loans where interest accrual has stopped because repayment is doubtful.

Banks with low Tier 1 equity value and high CRE exposure pose the highest threat to investors.

  • A low Tier 1 Capital to CRE Loan Value ratio is a critical vulnerability. 1 in 2 regional banks have a ratio of 40% or below. It means that a 40% decline in CRE loan values could completely erase banks' equity capital. This exposes investors to significant downside risk, especially in a volatile CRE market.

  • The Tier 1 Capital to CRE Loan Value ratio gives you a sense of the bank's resilience, specifically against CRE market downturns. It tells us how much CRE loan values need to drop to liquidate equity investors (independent of other bank losses). If the ratio is high, the bank has a sturdy equity cushion to absorb losses on its CRE loans. A low ratio indicates the opposite: a moderate drop in the value of CRE loans could severely erode or even wipe out the bank's equity.

  • This risk is amplified by higher delinquencies or the need to sell off loans quickly if depositors pull their funds, as banks are forced to recognize losses. Note that most of these loans are on the books at their original (book) value, not their current market value. Many of these loans are already worth less than what the books show. Banks aren't forced to reflect this lower value unless they sell the loans, disguising the actual risk level.

To wrap up, this analysis offers a snapshot of regional banks' exposure to the Commercial Real Estate (CRE) industry. Stay tuned for the next post in this series, where we will identify the banks at the highest risk based on these and other relevant variables.

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