The Bank of England’s stress testing of the UK banking system has exposed The Co-operative Bank, Lloyds Banking Group and Nationwide’s real estate loan books as being the most volatile in the case of a severe economic downturn.
In the hypothetical scenario created by the Bank of England, which included a 30% drop in commercial real estate values, it was expected that the Co-operative Bank – the only bank to fail the broader stress test – would have to write off 19.1% of the value of its loans, Nationwide 16.3% and Lloyds 16.1%.
The results show a strong improvement compared to the state of these institutions before the global financial crisis in 2008. But they also highlight the work that is still necessary when it comes to continuing their real estate deleveraging drives in order to reduce the risk the sector poses to the broader economy.
“There is no need for the banks to do anything over and above what they have already been doing in as far as disposing of commercial property loans,” said Neil Blake, head of EMEA research at CBRE.
“The world has of course overtaken this somewhat as the property market has been so healthy in 2014 that it’s been a good time to offload loans and if banks have needed to offload loans they have easily been able to do so.
“I don’t think there will be a change in strategy as plans are already in place and the speed at which they do so will depend on the strength of the market rather than pressure from the regulator.”
The other four banks that had their real estate books examined fared better, with Royal Bank of Scotland notably less exposed than its fellow part state-owned cousin Lloyds. RBS was expected to make an 11.2% write off under the bank’s assumptions with HSBC expected to encounter a 6.5% loss, Santander 5.4% and Barclays only 5%.
In terms of the quantum of potential write-offs, Lloyds and RBS still hold the property loan books that pose the biggest potential problems for the UK economy. Under the stress test scenario the amount of write offs by Lloyds would be £3.1bn and for RBS, £2.7bn, whilst Nationwide would also see a significant impact with a potential £1.1bn loss.
Whilst the Co-op’s book is proportionately the most volatile, as a result of it being smaller than the likes of RBS, Lloyds and Nationwide, it would only expect to see a loss of £0.4bn under such conditions. Santander and HSBC would be expected to lose £0.5bn and Barclays £0.4bn from their portfolios.
The results are a snap shot of the state of the institutions at the end of last year and the recapitalisation made by banks this year, through real estate deleveraging and other means, has not been taken into account. Given the improvement in the property market, the subsequent improvement of the banks’ real estate portfolios and the subsequent sales they have been able to make, the picture painted by the results is likely to be somewhat worse than the current reality.
Despite the relatively positive results the bank highlighted its concerns over the dramatic price changes within the commercial real estate market and said that it would continue to keep a close eye on the sector.
“[Real estate] impairment charges were projected to be lower in the stress scenario than those seen during the recent crisis… These results, however, do not suggest that there are no potential risks in the commercial real estate market… The UK commercial real estate market has seen strong price increases and rising activity since the 2014 UK stress test was initiated, and is an area that the bank continues to monitor closely. As a result, risks to commercial real estate portfolios are likely to be a feature of future stress-testing,” the results stated.
The Bank of England also released its systemic risk survey for the second half of 2014 today which showed that 36% of participants considered a risk of property price falls to be a key risk to the economy. This was down four percentage points compared to six months before, although dramatically up on the period H2 2011 to H1 2013 when the figure fluctuated between 16% and 25%. The bank surveyed 73 executives at key market participants.
Lastly, the bank’s financial stability report for December, also released today, highlighted the increasing importance of non-bank lenders to UK commercial real estate and their involvement in lending on higher risk assets. It stated:
“In the United Kingdom, lending to real estate companies fell by £15bn during the past year. Greater lending by non-banks offset part of the fall in banks’ lending to commercial real estate companies in the United Kingdom. Non-bank lenders provided 20% of the aggregate senior debt (£30bn) and more than 90% of the aggregate junior debt (£1.3bn) borrowed by commercial real estate companies during 2013.
“Market contacts suggest that non-bank lenders’ underwriting standards may have eased recently, as debt funds have lent to riskier borrowers — possibly reflecting the need to achieve target returns promised to investors. So far, that trend appears to be confined to the non-bank sector. And a recent Bank of England review of UK banks’ commercial real estate loan portfolios indicated that asset quality has improved since 2011.”
The paper also reiterated that it was considering how best to take forward the recommendation of the Real Estate Finance Group that a loan-level database for commercial real estate loans should be established.