Credit risk: Spotlight on Commercial Real Estate

December 2023

The sharp increase in interest rates since the start of 2022 continues to feed through to Europe’s real economy. Credit supply conditions have tightened¹ and this, together with the effect of higher borrowing costs, mean that credit risks are expected to increase².

So far, banks’ asset quality has remained robust³, and the ECB views banks under its supervision as well capitalised with robust liquidity and low levels of NPLs⁴. Even so, there are signs of deterioration, with some jurisdictions already reporting increased NPL volumes and heightened threats to asset quality⁵.

Banks’ Commercial Real Estate (CRE) portfolios are a particular area of supervisory focus. The ECB has observed a turn in market conditions⁶, with some CRE portfolios experiencing a fall in asset prices owing to falling collateral values, rising insolvency rates and increasing levels of borrower indebtedness⁷. This deterioration is underpinned by disruption from the COVID-19 pandemic, altered patterns of work, and uncertainty about long-term demand for office space.

The challenging outlook for CRE – and the fact that many European banks have material exposure to the sector – means it’s no surprise that 2023 has seen CRE portfolios receive increasing attention and ad-hoc requests from supervisors.

That includes the year’s twin on-site inspection (OSI) campaigns on IFRS 9 and BCBS 239, both of which have placed significant emphasis on CRE portfolios. OSIs and deep dive assessments of banks’ CRE exposures continue to be announced in multiple jurisdictions. In our experience these are typically intensive, time-consuming exercises requiring extensive responses from dedicated teams.

Particular areas of regulatory scrutiny include:

• Valuation frameworks and collateral values, including the timeliness of revaluations; the reliability of market values amid limited recent transactions; and the role of independent valuations.
• The treatment of CRE risks in terms of the accuracy of risk classifications, IFRS 9 stage transfers, and impairments.
• The adequacy of data management, aggregation and reporting – supervisors continue to detect data management gaps and examples of credit files not being kept up to date.
• The mapping of sustainable debt service capabilities on the basis of realistic estimates of borrowers’ future cash flows.
• The need to amend the current credit origination/underwriting standards.
• Banks’ interpretations of forbearance, with particular focus on consistent and proactive identification, the appropriateness of measures granted, and ongoing monitoring.
• The application of default characteristics - higher regulatory default settings imply that banks may need to make provisions earlier in future

How can banks prepare for supervisory scrutiny of their CRE portfolios?

In general, the ECB are looking for evidence that banks have implemented robust credit risk management policies and processes⁸; that they are using early warning indicators to identify any changes in asset quality; that they are provisioning adequately – including the use of overlays; and that loan losses are being recognised through timely impairments⁹.

Based on KPMG professionals knowledge of recent OSIs and supervisory activity, the following actions as being among the most important for banks to prioritise:

• Update collateral values for properties in critical asset classes (i.e. office space)
• The assessment of current credit origination and underwriting standards
• Review debt service capacity calculations, taking current rental agreements into account
• Check the recoverability of third-party contractual obligations (e.g. sponsors, guarantors)
• Analyse and review current forbearance status for critical creditors
• Integrate segment-specific early warning signals and UTP triggers into credit processes

Economic uncertainty implies that the ECB’s focus on CRE portfolios will continue. The ECB has also been clear that banks failing to remediate weaknesses in their management of CRE risks could face supervisory actions including targeted Pillar 2 requirements, enforcement measures or sanctions.

Therefore banks should ensure they’re prepared for continuing regulatory scrutiny of this key area during the year ahead.