Commercial Real Estate Exposure, Financial Pressures Could Lead to Bank Consolidation, Yellen Says

U.S. Secretary of the Treasury Janet Yellen delivers remarks at Johns Hopkins University’s School of Advanced International Studies in Washington on April 20, 2023. Anna Moneymaker/Getty Images

More consolidation in the U.S. banking system wouldn’t be surprising, considering the current environment in the financial sector, according to Treasury Secretary Janet Yellen.

While Yellen acknowledged that she doesn’t wish to see further consolidation by some smaller firms threaten the diversity of the banking sector, she said she would understand because of the enormous pressures faced by many financial institutions.

“There is motivation to see some consolidation, and it wouldn’t surprise me to see some of that going forward,” she told CNBC on June 7.

There were a total of 4,135 commercial banks as of the end of 2022, down from the peak of 14,469 in 1973, according to data from the Federal Deposit Insurance Corp. (FDIC).

With the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank, as well as several other small- and mid-sized institutions experiencing challenges, there has been widespread concern that the industry is becoming too consolidated and dominated by a handful of entities.

A security guard at the failed Silicon Valley Bank monitors a line of people outside its office in Santa Clara, Calif., on March 13, 2023. Justin Sullivan/Getty Images

Yellen isn’t the first official to sound an alarm regarding the shrinking number of banks.

Federal Reserve Gov. Michelle Bowman warned at the Wharton Financial Regulation Conference in Philadelphia in April that the United States should “be concerned,” noting that it’s essential to have “a robust and diverse banking system.”

Liquidity in Banking System

Liquidity in the banking system is strong, according to Yellen.

She told CNBC’s Andrew Ross Sorkin that stress tests of the country’s largest financial institutions indicate that they can weather potential turbulence in the economy.

“My overall read is that the level of capital and liquidity in the banking system is strong, and while there will be some pain associated with this, the banks should be able to handle the strain,” she said.

At the same time, banks could be at risk because of exposure to the weakening $20 trillion commercial real estate market. If the situation metastasized into a full-blown crisis, Yellen thinks it could result in more bank failures.

“I do think that there will be issues with respect to commercial real estate,” she said. “Certainly, the demand for office space since we’ve seen such a big change in attitudes and behavior toward remote work has changed and especially in an environment of higher interest rates.”

Yellen noted that banks are likely “preparing” for difficulties in this arena moving forward.

A recent report by researchers at the Columbia Business School and New York University Stern School of Business estimates that there has been a more than $506 billion decline in office values since 2019. That’s troublesome because the paper projects that banks control about 61 percent of commercial property debt.

A pedestrian walks by a commercial property for lease in San Francisco on Oct. 27, 2022. Justin Sullivan/Getty Images

Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, recently forecast that about half of the $2.9 trillion in commercial mortgages will be renegotiated over the next two years, at a time “when new lending rates are likely to be up” by as much as 450 basis points.

The additional problem is that small lenders account for as much as 70 percent of commercial real estate loans, with some reports suggesting that small banks hold roughly four times more exposure to commercial real estate loans than the big banks.

A wide range of financial experts has alluded to the sharp decline in deposits as evidence that liquidity might not be as ample as officials assert.

The Federal Reserve’s H.8 data show that commercial bank deposits have been on a downward trend since August 2022, tumbling by nearly $1 trillion, or 4.4 percent, to $17.238 trillion.

A trader works on the floor of the New York Stock Exchange on May 22, 2023. Brendan McDermid/Reuters

Market experts have also been concerned about potential liquidity issues emanating from the U.S. government’s bond issuance.

The Treasury Department is on track to issue as much as $1 trillion in bonds to replenish its Treasury General Account (TGA), which was depleted during the debt ceiling battle in Washington. Many analysts warn that unleashing new short-term debt could drain bank reserves when liquidity is needed to cushion the blows from the shocks over the past three months.

‘Path’ for Inflation

Yellen, former chair of the Federal Reserve, thinks there’s a “path” for inflation to ease further amid a resilient job market.”

“I’ve been saying now for almost a year that I see a path to bringing down inflation while maintaining a strong labor market,” she said.

The May consumer price index (CPI) report will be released on June 13. The Cleveland Fed’s Inflation Nowcasting is predicting a 4.1 percent annualized print and a 0.2 percent month-over-month increase. Core CPI, which strips the volatile energy and food components, is expected to ease to 5.3 percent year-over-year and rise by 0.5 percent month-over-month.