It’s clear that new rules for how banks build their balances are coming. But we don’t know when they will come or how substantial the changes will be.
The updates to the Basel III international capital rules, called the Basel III Endgame, were proposed by federal bank regulators—the Office of the Comptroller of the Currency, the FDIC and the Federal Reserve—one year ago. The aim of the new rules is to strengthen the banking system by requiring banks to significantly raise their capital reserves and take other risk-reducing measures. Scheduled to take effect July 1, 2025, the proposal, which includes banks with $100 billion or more in assets, provides a three-year grace period for banks to comply.
But following harsh pushback from the financial industry and an impact study, Fed Chair Powell in March told Congress he anticipated “broad and material changes” to the proposal, and he did not rule out reproposing the rules. Last week, he indicated to Congress that the final rules, or the next proposal, could be ready at the beginning of next year. That uncertainty has commercial real estate finance professionals anticipating the worst at a time when liquidity is already strained.
“The MBA has been advocating very strongly against that rule because it could have a negative impact on commercial and residential mortgages,“ said Stephanie Milner, associate vice president of commercial and multifamily at the Mortgage Bankers Association. “When you increase capital requirements for banks, it obviously impacts their appetite for lending overall and the sort of pockets they look to for lending activity.”
The proposed improvements, like the original Basel III international accord of 2009, are aimed at preventing another financial meltdown like the 2008 GFC. As such, the proposal is estimated to result in an aggregate 16 percent increase in common equity, tier 1 capital requirements for affected bank holding companies, principally the largest and most complex banks, said Washington, D.C.-based David Wessel, senior fellow in economic studies & director at The Hutchins Center on Fiscal and Monetary Policy at the Brookings Institute, in a white paper.
The effects of the Basel III Endgame on individual banks would vary based on activities and risk profile, but, Wessel noted, most banks currently have enough capital on hand to comply with proposed requirements.
Increasing bank capital requirements will further decrease banks’ appetite for CRE, said Stephanie Miller, Associate Vice President of Commercial Multi-Family, MBA.
The Fed’s most recent bank stress test, in fact, verified this contention. This annual tool used to measure large banks’ ability to support the economy in a downturn, showed that banks would endure greater losses in 2024 than last year but are well positioned to weather a severe recession and stay above minimum capital requirements.
“People like to point to the S&P and that a few of the banks failed last year,” said Milner, “but No. 1, that didn’t have anything to do with banks being adequately capitalized nor their commercial real estate holdings, and, No. 2, bank failures are going to happen.”
Critics of the proposal have voiced concerns over the negative impact of higher bank capital standards on availability of capital to lend, lending policies and GDP. According to Wessel, Fed Gov. Christopher Waller, who voted against the proposal, is concerned that it would raise the cost of debt by moving lending activities outside the regulated banking system to less regulated lenders.
“With commercial real estate continuing to become more expensive for lenders, banks will continue to exit the space, providing alternative lenders a seat at the table,” said Meredith Ager, EY principal for strategy and transactions, financial services and real estate, but noted that alternative lenders, outside of CMBS, are more costly than banks and often the lender of last resort.
Milner concurred, noting that funds and alternative lenders charge significantly higher interest rates than banks—10 percent or more.
Business Without Banks
While there are other lending sources available, without banks it would be very difficult for the lending community to meet the needs of the commercial real estate industry, suggested San Francisco-based Michael Heagerty, a principal & chief financial officer for Gantry, a mortgage banking firm, pointing out that banks are the largest holders of commercial real estate debt.
Banks represent 40 to 45 percent of all commercial real estate originations in most years, with the largest banks accounting for about 25 percent of originations, while the newly affected banks—$100 to $700 billion of assets—typically originate 30 percent, according to Rebecca Rockey, deputy chief economist & global head of Forecasting at Cushman & Wakefield.
“So we’re talking about up to 55 percent of 40 to 45 percent of the market being most affected by Basel III,” she noted.
As CRE loans become more expensive for banks, lending will move further outside the regulated space, noted David Wessel, Senior Fellow in economic studies at the Brookings Institute.
Meanwhile, the commercial real estate debt market is already pressured by higher CRE interest rates. ”It’s very, very difficult out there right now, as banks have essentially pulled out of commercial (real estate) lending, particularly in the construction market,” Milner said. “It’s not that developers can’t get a loan, they just can’t get it at an interest rate that works.” The higher capital standard would further reduce banks’ willingness to loan and tighten lending policies.
High interest rates are by no means the only challenges for commercial real estate. ”Inflation is causing expenses to skyrocket, especially for insurance coverage, which lowers property cash flow and valuations,” Ager said.
“In addition, office properties are confronting starkly different market conditions resulting from the permanence of post-pandemic remote work patterns, which have led to historically high vacancy rates of approximately 20 percent in certain U.S. cities, especially in high tech locations such as San Francisco and Seattle. This new pattern does not simply affect office. Renters living in expensive downtown submarkets continue to favor areas with lower costs of living, impacting the multifamily space.”
Raising capital reserve levels an estimated 16 percent “could have a macro-drag effect across all types of loans, as credit availability would tighten,” said Cliff Stanford, partner at Alston & Bird and leader of the firm’s Bank Regulatory Team.
Heagerty is particularly concerned about the proposal’s impact on affordable housing production. “Banks are an important source of construction loans for affordable housing,” he said. “The regulators should be finding ways of encouraging lending for affordable housing, rather than further restricting capital flow into those markets.”
Increased Risk Management
Basel III also will put pressure on banks to adopt a more in-depth risk management system, leading to stricter lending standards for CRE loans as banks aim to manage and mitigate their credit-risk exposures. noted Nicole Schmidt, a broker at Built Technologies.
A requirement for banks to factor risks associated with their operational costs into their capital reserve equation would further limit the amount of capital available to loan. Under current rules, only the biggest, most complex banks, offering “beyond products and services” like financial advisory and investment services, insurance, investment, and wealth management, are required to hold capital against operational risk.
The proposal, however, would extend this rule to more banks, according to Wessel, who noted that operational risk in the proposal is measured by a “business indicator” based on the size, complexity, and specifics of a bank’s lending, investing, and financing activities and by its history of operations-related losses.
The industry is waiting with “baited breath” to see if rules will be re-issued for reproposed, said Cliff Stanford, Partner at Alston & Bird and leader of the firm’s Bank Regulatory Team.
Members of the Fed board have been working on proposal revisions that would significantly curtail the capital impact for larger banks. However, regulators are split on how to proceed, with the Fed open to a re-proposal and the other two agencies viewing it as an unnecessary step that would delay implementation of the project for months, reported Reuters.
The re-proposal would require a period for public comment, as Powell told the Senate Banking Committee, “When there are broad, material changes, that has been our practice.”
According to Standard, “the entire banking industry is waiting with bated breath for a decision from the Fed as to whether they will finalize the rule as proposed or re-propose the rule.”
What To Leave In and What To Leave Out
While regulators have not disclosed details of the proposal’s changes, eight industry executives, who are in regular contact with agencies and regulatory officials, said in an earlier Reuters report, that officials are also expected to scrap or reduce higher risk weights on mortgages to low-income borrowers and on renewable energy tax credits.
There are a couple positives in the current proposal, however. Milner added, noting that the risk weight for statutory multifamily mortgages—those that meet prudent underwriting standards and certain criteria that provide a 50 percent risk-weight exposure—is not changing from what’s currently in place. Risk weight refers to a system for classifying loans on assets based on their risk level and potential for loss. In this system, each asset’s loan is multiplied by a percentage factor to reflect its risk of loss to the bank
Additionally, Milner said that currently other types of commercial loans generally receive 100 percent risk weight if non-delinquent. The new proposal creates an LTV striation, so that if a loan has a lower LTV, it will get a little bit lower risk weighting than under the current regime.
But, while risk-weights on the various types of commercial real estate will remain the same, given the higher regulatory capital on net that banks will need, pricing, spreads over fund costs, or borrower interest rates, are likely to go up, Rockey observed.
Borrowers with maturing leans will face even greater scrutiny, noted Nicole Schmidt, Commercial Real Estate consultant at Built Technologies.
“In that case, other lender types stand to become comparatively more competitive in terms of both debt costs and debt terms, which could help to funnel more loan demand towards alternative lender sources, such as commercial real estate debt funds and private lenders that have been amassing significant capital to deploy into this normalized interest rate environment, added Rockey.
She noted that alternative lenders share to the commercial real estate debt market has already gone up this year, with debt funds share increasing 16 percent year-to-date, vs. 9.4 percent pre-pandemic, reflecting a dramatic 71 percent increase in market share. Private lenders sources also are capturing a larger share of the market, vs. pre-pandemic, of 3.6 percent YTD vs. 1.0, respectively.
On the other hand, the proposal would impose greater scrutiny of borrowers’ financial profiles, creating the concept of “cross-default of the commercial loan,” Milner noted. This means that when making loan decisions, bankers must consider loan repayment history across the borrower’s entire portfolio, regardless of whether the borrower is current on all other loans.
Noting that this rule would affect all commercial real estate types, Ager explained that historically, commercial real estate loans were structured on a non-recourse basis, allowing lenders to take the collateral named in the loan agreement in a default situation. “Under this new proposal, the bank would need to calculate risk on the total borrower exposure,” she said. “Therefore, a 150 percent risk weight would be assessed to any defaulted loan and all other loans to the same borrower, regardless of loan status—current or delinquent.”
This rule is also not clear about whether it applies just to the actual borrowing entity or the parent company, too, Milner noted. “If it ends up being the parent entity, that is really, really bad for commercial lenders, because banks don’t have a system in place to share information, particularly if it involves a non-bank lender not subject to Basel,” she added. It, therefore, would be problematic for banks to figure out whether this borrower or its parent company has defaulted on loans with other lenders.
Schmidt also expects changes in banking rules to have a particularly negative impact on borrowers with maturing loans, as they would face more rigorous scrutiny of their creditworthiness and the underlying property’s market conditions. “Borrowers with strong credit profiles and lower-risk properties may benefit from potentially lower borrowing costs, while those with higher-risk profiles may find it more challenging and expensive to refinance their loans,” she said.
While banks currently have about four years to comply with the new rules, Ager believes that banks will begin adjusting their lending strategies now to ensure future compliance and portfolio optimization. “Overall, lending to commercial real estate has already been diminished, with many banks halting certain areas of real lending, specifically construction,” she said.