“A lot of what’s been going on is people didn’t want to recognize how serious the problem was, but now it’s becoming pretty obvious,” said Desmond Lachman, an economist from American Enterprise Institute.

Regional banks hold more than two-thirds of the roughly $2.8 trillion in outstanding loans for U.S. commercial real estate properties. And, according to the National Association of Realtors, the historically low vacancy rates seen throughout 2023 aren’t expected to reverse themselves any time soon.

Tomasz Piskorski, a professor at Columbia Business School, noted that “everyone was playing the waiting game,” hoping interest rates would soon fall, but with the latest Consumer Price Index report showing inflation still above 3%, it’s unlikely that the Federal Reserve will approve cuts in March, leaving the current rate at 5.25% to 5.5%.

High rates have already destroyed about $2 trillion in asset value for banks, according to Piskorski, who contributed to the paper “Monetary Tightening, Commercial Real Estate Distress, and US Bank Fragility,” which takes a closer look at the number of properties where outstanding debts exceed listed values. Their research shows that currently about 14% of all CRE loans and 44% of all office loans are at high risk of default, and if that default rate were to reach 20%, over 380 banks would be at risk of insolvency.

All of this comes as the Federal Reserve has announced that it won’t be extending the Bank Term Funding Program, a short-term liquidity option for banks established in March 2023 in the wake of the Silicon Valley Bank crisis.

“A lot of what they tried to do after the SVB collapse was to create a perception that they, to an extent, will back the banking system,” Piskorski said. “It’s a confidence game at the end of the day.”

Lachman and Piskorski both also noted that the system is holding steady because of that confidence: Regional bank customers, unlike many last year, aren’t withdrawing deposits en masse.

‘Too slow to act’

This isn’t to say the one-year BTFP program was perfect, Lachman added. But given the current economic climate, he said he was surprised to see it ending outright instead of being updated or amended, partially because some regional banks were using BTFP loans at lower rates to earn interest elsewhere at higher rates. Piskorski said he was less concerned with the federal program expiring, with borrowers still having ample time to repay those loans.

However, both experts agree that the key issue is interest rates—both for their direct impact on banks and because of the pressure exerted on the commercial real estate sector. The Fed has been too focused on inflation at the expense of financial stability, Lachman said. And, Piskorki added, federal regulators remain too focussed on big banks and not regional banks, which could benefit from having higher capital minimums.

Fed Vice Chair of Supervising Michael Barr noted at a Columbia Law School Banking Conference last week that Fed supervisors are looking to ensure banks are managing risks, including those related to interest rates, but are especially focussing on CRE loans.

“Federal Reserve supervisors did not identify issues quickly enough,” Barr admitted, “and when we did identify risks, we were too slow to act with sufficient force to change management behavior.”