On December 11, 2015, The Wall Street Journal reported that Fed officials are concerned about banks’ increasing investment in commercial real estate. Some regional Fed presidents are worried that low interest rates and investors’ search for yield have created a new bubble in commercial real estate that could affect financial system stability.
Dianna Ingram | Bergman Group
However, while the Fed is responsible for this problem, its interest-rate policies are only a small factor in a much larger issue. What is happening with bank commercial real estate lending today is part of a long-term process in which the bank intermediation system — where a bank is both a borrower and a lender — is gradually being displaced by the agency intermediation system that is common in the capital markets. In an agency intermediation system, the intermediary between a borrower and a lender is a broker instead of a principal.
As shown in figure 1, since the late 1980s, the capital markets have significantly out-competed the banking industry for financing business corporations. This is because thousands of firms, large and small, have gained access to the credit markets by registering their debt securities with the Securities and Exchange Commission (SEC). Beginning in the late 1980s, technological change — particularly the advent of rapid and inexpensive data transmission — made it possible for investors to obtain financial information inexpensively, through access to regular company filings with the SEC; over time, the information advantage of banks as investment intermediaries was substantially eliminated.
Figure 1. Bank Loans’ and Fixed-Income Securities’ Intermediation for Business Firms and State and Local Governments
As a result, in today’s financial world, banks are increasingly confined to providing credit to firms — such as small businesses and commercial and residential real-estate developers — that do not have access to the securities markets. It should be no surprise then that banks are overinvested in commercial real estate; they are gradually being driven out of other profitable credit-granting businesses. That is why the formation of new banks is at record lows.
Thus, as shown in figure 2, about half of all bank loans today are collateralized by real estate. Commercial and industrial loans — mostly unsecured loans to general business firms — have continued their long-term decline as a percentage of all bank loans. Moreover, the totals for bank loans continue to decline relative to the size of the economy as a whole. These are ominous trends for banks, which are becoming less and less diversified relative to the growing financial market.
Figure 2. Change in the Composition of Commercial Bank Loan Portfolios
Source: Alex J. Pollock, “Can Banks Resist the Real Estate Temptation?” Housing Finance International (Winter 2014): 12.
The solution to this problem is to enable banks to participate more fully in the capital markets. However, the Dodd-Frank Act has moved in the opposite direction, prohibiting banks and their affiliates from engaging in the trading of securities for their own account — an activity that is less risky than making loans and was an important source of bank profits before the act was adopted.
Another area where Dodd-Frank has limited bank activity is derivatives, where heavy new costs have been imposed on the market and many transactions have been forced out of banks into clearinghouses. Proposals to restore Glass-Steagall will further isolate the banking industry from continuing technology-driven changes in the financial industry.
The reaction of the Fed and other bank regulators to the growth of the capital markets has been well in line with the customary response of regulators. Instead of proposing to expand the regulated industry’s ability to compete with new challengers, regulators have been trying to reduce competition for banks by restricting the growth of the capital markets, which they call “shadow banking.” The Financial Stability Oversight Council, created by the Dodd-Frank Act and dominated by the Fed and other banking regulators, has been working with the Financial Stability Board in Europe to find ways in which prudential regulation — regulatory control of risk taking — can be imposed on firms such as broker dealers, asset managers, hedge funds, and insurance companies.
If they succeed, the US economy’s growth will surely be stunted, but banks will still be locked in a regulatory death spiral, forcing them into financing narrower and riskier sectors of the economy where the borrowers cannot access the capital markets.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.
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