Big banks face huge unexpected risks from real estate loans

• The study sheds light on the significant risks posed by bank credit lines to non-bank financial intermediaries (NBFIs), specifically Real Estate Investment Trusts (REITs) investing in commercial real estate (CRE).
• Large banks face substantial indirect exposure via credit lines provided to REITs while small and mid-sized banks have direct exposure to CRE through term loans.
• The researchers highlight the need for regulators and policymakers to consider these indirect exposures when assessing the stability and resilience of large banks.

New research shows that big banks are facing huge and unexpected risks when it comes to loans given to companies like Real Estate Investment Trusts (REITS) who invest in commercial real estate (CRE).

The researchers say that these loans are often not evaluated when it comes to bank stress testing, meaning that banks are understating the impact of these credit lines, and thus could find themselves at serious risk of instability due to their own lack of testing.

The paper, titled "Shadow Always Touches the Feet: Implications of Bank Credit Lines to Non-Bank Financial Intermediaries," was conducted by Viral V. Acharya, from NYU Stern School of Business, Manasa Gopal, from Georgia Institute of Technology, as well as Maximilian Jager and Sascha Steffen, both from Frankfurt School of Finance & Management.

The findings highlight that Real Estate Investment Trusts (REITs) utilise bank credit lines more extensively than other corporations. This high utilisation is closely tied to the performance of the underlying real estate assets, especially during economic downturns, such as post-COVID-19 or when interest rates rise, where REITs draw heavily on these credit lines to manage their operations and cover losses. This clearly shows that there is a significant risk for large banks, which experience financial strain during these stress periods.

This oversight can lead to an understatement of the true risks that banks face regarding CRE. To address this, the authors propose a methodology to include this indirect exposure in bank capital stress tests, providing a more accurate and comprehensive assessment of the risks faced by large banks.

"This study reveals the significant yet often overlooked risks posed by bank credit lines to non-bank financial intermediaries, particularly REITs investing in commercial real estate”, says Sascha Steffen, DWS Senior Chair in Finance and Professor of Finance at Frankfurt School. “By highlighting the higher utilisation rates of these credit lines during economic stress and proposing new methodologies for stress tests, we underscore the need for regulators and policymakers to account for these indirect exposures. Our findings suggest that without this consideration, the systemic risks to large banks and the broader financial sector are substantially underestimated."

The study emphasises the need for regulators and policymakers to consider these indirect exposures when assessing the stability and resilience of large banks. By accounting for the credit line channel, a more accurate picture of the systemic risks associated with the CRE market can be achieved, say the researchers.

You can find the full paper here.