The Pandemic's Impact on Credit Risk: Averted or Delayed?
The COVID-19 recession resulted in historic unemployment and a significant shock to much of the service sector. Despite these macroeconomic challenges, banks’ risk-based capital buffers remain high and the number of bank failures remains low. Government relief programs, including the Coronavirus Aid, Relief, and Economic Security (CARES) Act, both directly and indirectly helped stabilize bank balance sheets during the crisis.
Section 4013 of the CARES Act provided operational relief to financial institutions by giving them the option to not classify and account for certain COVID-19 modified loans as troubled debt restricting (TDR). Furthermore, it offered capital relief, as banks are not required to hold additional capital associated with past due loans. We use Call Report data to study recent commercial real estate (CRE) concentration dynamics and investigate their relationship with Section 4013 loan modifications. We document the recent increase in the CRE concentration and the simultaneous decrease in underlying loan quality, accompanied by the rapid increase in loan modifications during the COVID-19 recession.
Our model shows that banks’ CRE concentrations are positively associated with loan modifications. Furthermore, we find high levels of Commercial Mortgage Backed Security (CMBS) delinquencies and rising allowance levels for CRE as the U.S. economy exits the COVID-19 Recession. These risk factors could be early indicators of future increased credit losses and possible bank stress. Since the true quality of the modified loans will be revealed to regulators, per the CARES Act stipulations, only 60 days after the pandemic emergency end date or the end of 2021, our work provides insights into the types of portfolios where the poor loan quality problem is likely to be particularly acute.
About the Authors
Sung Je Byun is a research economist in the Supervisory Risk and Surveillance division at the Federal Reserve Bank of Dallas.
Aaron Game is a senior financial institution policy analyst at the Federal Reserve Board.
Alexander Jiron is a senior financial institution policy analyst at the Federal Reserve Board.
Pavel Kapinos is a senior research economist in the Supervisory Risk and Surveillance division of the Federal Reserve Bank of Dallas.
Kelly Klemme is a senior data scientist in the Banking Supervision and Regulation Department at the Federal Reserve Bank of Dallas.
Bert Loudis is a senior financial institution policy analyst at the Federal Reserve Board.