The commercial credit market in the US is facing a potential crisis in the coming years, as many loans originated before the recent interest rate increases will be adjusting to higher rates in 2024, 2025, and 2026. This could lead to increased defaults, lower profitability, and higher risk for lenders, especially community banks that rely heavily on commercial lending. The recent earnings report from New York Community Bancorp (NYCB), one of the largest community banks in the country, showed a significant decline in net income due to higher provisions for loan losses and lower net interest income. This may be a sign of the challenges that community banks that are not prepared may face as the commercial credit cycle turns. And the longer that the Federal Reserve waits to loosen monetary policy, the higher the probability the realization of the cresit crisis. 

The Commercial Credit Cycle and Its Impact on Community Banks

Commercial credit is a cyclical business, as lenders tend to loosen their underwriting standards and extend more credit when the economy is booming, and tighten their standards and reduce their exposure when the economy is slowing down. The last decade saw a prolonged period of low interest rates, high liquidity, and strong economic growth, which fueled a surge in commercial lending, especially in sectors such as real estate, construction, auto dealers, and other main street businesses.

About $1.2 trillion or 40% of the current outstanding commercial loans in real estate originated before 2019. This means that these loans were issued when the commercial real estate market was at its peak, and may face challenges in refinancing or repayment in the current environment of high commercial real estate vacancy rates. According to Moody’s Analytics about $1.4 trillion of commercial real estate loans will mature between 2024 and 2026 in the US. This represents about 47% of the total outstanding commercial real estate debt as of December 2023. The majority of the maturing loans are backed by office, retail, and multifamily properties.

Community banks, which are typically defined as banks with less than $10 billion in assets, are particularly exposed to the commercial credit cycle, as they account for about 40% of the total commercial and industrial loans and about 50% of the total commercial real estate loans in the US. Community banks tend to have more concentrated portfolios, less diversified sources of income, and less access to capital markets than larger banks, making them more vulnerable to credit shocks and market disruptions. Some community banks also tend to engage in more relationship-based lending practices, which could lead to extend forbearance or restructuring to troubled borrowers, rather than recognizing losses and immediately writing off bad loans. This may delay the recognition of the true extent of the problem and erode the banks' capital and liquidity positions over time.

As the value of commercial real estate continues to decline, the average community bank had a loan-to-asset ratio of 76.4% as of the third quarter of 2023, compared to 63.6% for the average non-community bank, according to FDIC data. In addition, the average community bank had a higher exposure to industrial and commercial real estate loans relative to non-community banks at the end of 2023. Community banks held about $1.1 trillion or 37% of their total loans in industrial and commercial real estate loans, while non community banks held about $1.9 trillion or 16% of their total loans in this category. This means that community banks are more concentrated and dependent on the performance of the industrial and commercial real estate sector than non-community banks.

The impact of the commercial credit crisis will vary by sector and region, depending on the nature and duration of the economic disruption caused by high vacancy rates and sustained high interest rates and the resilience and recovery of the businesses. Some of the sectors that are most likely to face higher default rates and lower loan demand include real estate, construction, and auto sales.

It would be wise for community banks need to take proactive and prudent measures to prepare for the looming commercial credit crisis and ensure the protection of their financial health and stability. Some of the steps that community banks should consider are:

• Review and monitor their commercial loan portfolios regularly and identify the segments and borrowers that are most at risk of default or refinancing stress. Community banks should also conduct stress tests and scenario analyses to assess the potential impact of various economic and market conditions on their loan performance and capital adequacy.
• Strengthen their loan loss reserves and capital buffers to absorb potential losses and meet regulatory requirements. Community banks should also diversify their funding sources and maintain adequate liquidity to meet their obligations and support their lending activities.
• Enhance their credit risk management and underwriting practices to ensure that they are aligned with the current and expected market conditions and borrower profiles. Community banks should also review and revise their loan pricing and terms to reflect the higher risk and cost of capital in the commercial credit market.
• Seek opportunities to restructure, refinance, or sell their troubled or non-performing loans, where feasible and beneficial, to reduce their exposure and improve their asset quality. Community banks should also work with their borrowers to provide relief or assistance, where appropriate and warranted, to help them overcome their financial difficulties and avoid default.
• Explore new or alternative sources of revenue and growth, such as fee-based services, niche markets, or partnerships, to offset the decline in their net interest income and profitability from their commercial lending activities.

Conclusion

The commercial credit market in the US is facing a potential crisis in the coming years, as many loans originated before the recent interest rate hikes will be adjusting to potentially higher rates in 2024, 2025, and 2026. This could lead to increased defaults, lower profitability, and higher risk for lenders, especially community banks that rely heavily on commercial lending. Community banks need to take proactive and prudent measures to prepare for the looming commercial credit crisis and protect their financial health and stability. By doing so, community banks can not only survive, but also thrive, in the challenging and dynamic commercial credit environment.