CRE stress could drive global bank downgrades

“Final implications from these structural challenges are uncertain, but further sharp price corrections would result in higher-than-expected credit losses for banks globally,” the report said.

To test the possible rating impact of that view, Fitch examined a simplified stress scenario on a sample of 16 global banks with large CRE exposures — namely banks with at least US$50 billion in total assets, and CRE exposures of at least double their common equity tier 1 capital.

That exercise found that about half of the banks it examined would be vulnerable to a rating downgrade in a stress scenario. Specifically, it examined the impact of a rapid shock, including a sharp increase in defaults for the CRE sector, particularly for exposures with high loan-to-value ratios (above 80%).

While the rating agency’s exercise didn’t consider the banks’ lending standards, or the quality of the borrowers, Fitch said the “instantaneous shock of the stress results in immediate losses and capital erosion.”

But it also said the exercise “confirms the resilience of the peer banks’ ratings, as no bank would have a multi-notch downgrade” in this scenario — all of the banks at risk for a downgrade would only face a single-notch downgrade.

For the highest-rated banks, increased credit losses would be “easily absorbable” by their operating profits, “but their high rating level means that headroom to withstand a stress significantly worse than baseline forecasts is very limited,” the report said.

The other banks that would face a downgrade under this stress scenario are banks with “relatively high exposure to CRE, which would result in a sharp increase in projected impaired loan/gross loan ratios,” Fitch said.

The rating agency noted that it does not expect a rapid shock in the CRE sector. More realistically, it expects “elevated but manageable credit losses over several years as problem loans emerge and are worked out.”

Additionally, if the sector deteriorates, Fitch said it “would expect banks to actively reduce their impaired assets and to use loan loss allowances to facilitate the sale of distressed assets.”