The US Federal Reserve has published its latest Financial Stability Report, which includes the findings of a survey of 25 industry stakeholders, aimed at gauging perceptions of risk to the outlook.
Respondents (including brokers, investment funds, research and advisory firms, and academics) flagged five headwinds – persistent inflationary pressures, the commercial real estate (CRE) market, a re-emergence of banking stress, market liquidity constraints, and a slowdown in the Chinese economy and financial sector.
When compared to the previous survey in May, a greater share of respondents noted concern over the outlook for the commercial real estate market, up from 52 per cent to 72 per cent.
Respondents said structural shifts in demand, higher interest rates, and falling property prices could trigger a marked deterioration in CRE conditions.
These risks, respondents added, are heightened by the high level of exposure to commercial real estate loans among smaller, less-resilient US banks.
“Survey respondents viewed small and regional domestic banks as particularly vulnerable due to their higher concentration of CRE exposures, which could lead to tighter bank lending conditions,” the report stated.
According to research from global investment firm JP Morgan, commercial real estate loans make up 28.7 per cent of assets, compared with only 6.5 per cent at larger banking institutions.
These concerns were shared by the Fed in its own assessment of the CRE market, warning a significant slowdown in economic growth could “precipitate strains”.
“If the economy were to slow unexpectedly, profits of non-financial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases would likely lead to financial stress and defaults at some firms,” the Fed warned.
This could, in turn, trigger job losses and strains on households, and potentially lead to a mild recession.
“Investor risk appetite and asset prices might decline, and valuations in the office building sector appear particularly vulnerable given the ongoing uncertainty surrounding post-pandemic norms regarding return to work,” the Fed added.
“A correction in office property valuations accompanied by even a mild recession could result in significant losses for a range of financial institutions with sizable exposures, including some regional and community banks and insurance companies.”
A subsequent credit crunch could add to these pressures, the Fed continued, with impacted lenders limiting the flow of credit and accelerating the broader economic slowdown.
“While stress tests suggest the largest banks are well positioned to withstand a severe recession and contraction in CRE markets, other financial institutions with concentrated exposures could be forced to retrench,” the Fed stated.
