U.S. Banks Pass Fed’s Stress Test Amid Rising Commercial Real Estate Risks

By Katie Borchetta · June 27, 2024

On June 26, the major U.S. banks passed the Federal Reserve’s annual stress test, which included a scenario with a 40% drop in commercial real estate values. This result alleviated some concerns about the banking sector amid challenges landlords face due to prolonged high interest rates.

As the risks in the CRE market increased, investors were keen to see the outcomes of the Fed’s stress tests. These tests assess the vulnerability of U.S. banks, particularly at a time when office vacancies are at a historic high of 20% due to ongoing remote work trends from the pandemic.

These test results should provide some reassurance that banks can endure a severe economic downturn. However, he also noted that the Fed’s positive results do not imply that the CRE market is completely secure, as the credit cycle is still in its early stages.

The Fed’s stress tests evaluate banks’ financial stability in a hypothetical severe economic crisis, which includes a 36% drop in U.S. home prices, a 55% decline in equity prices, and a 10% unemployment rate. The results, released on Wednesday, determine if banks can maintain lending during a significant global recession and indicate the necessary capital to be considered healthy, as well as the potential for shareholder returns through dividends and buybacks.

The 31 large banks that were tested showed they could absorb nearly $685 billion in losses. This testing followed over a year after the collapse of mid-size banks like Silicon Valley Bank, Signature Bank, and First Republic, which sparked criticism that the Fed had not adequately accounted for the impact of rising interest rates.

The Mortgage Bankers Association stated that commercial real estate is under scrutiny as $929 billion out of the $4.7 trillion in outstanding commercial mortgages are set to mature this year. This maturity comes amidst declining property values and lower rental incomes.

Analysts foresee significant challenges for the CRE sector, with Moody’s Ratings indicating that banks still face considerable risks. Among the tested banks, Goldman Sachs had the largest anticipated loan loss for commercial real estate with 15.9%, followed by RBC USA at 15.8%, Capital One at 14.6%, and Northern Trust at 13%.

One critique of the Fed’s stress tests is that they did not include regional banks, which hold the majority of CRE loans and are subject to less regulation than their larger counterparts.