(Detailed charts supporting the comments herein are in the Appendix below) 

Among many other events, 2024 will mark the passage of Basel III in the banking industry. 

The most recent proposal increases the banks’ Tier 1 equity capital requirements by 16% (or by 19% for banks with $100BN or more in assets). 

What is Tier 1 capital?
Tier 1 capital is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings).  

Think of it as equivalent to your personal net worth (assets minus liabilities) or in other words the cushion available to withstand (i) losses or (ii) further increase in obligations or (iii) a rapid decline in assets (while it is not calculated 100% the same, it conceptually measures the same, i.e. the cushion component). 

What is next?
January 16, is the deadline for the public to comment on the proposal, which has been contemplated since before CV19. If the proposal passes in 2024, it will be implemented in 2025. 

What is the potential outcome?
While it is expected that the bulk of the capital increase would be derived from reduction in trading and investing activities, it may also impact lending among many banks…or at a minimum their lending appetite. 

We saw a big shakeout in the industry post the Global Financial Crisis whereby the larger “too big to fail” banks had higher compliance and capitalization requirements, which will now extend to mid-tier banks. 

We are also seeing transition of deposits from smaller to larger financial institutions. Added to that is the distress in CRE (with office leading the way) that will cause potential loan losses or at a minimum higher reserves for losses. 

As a result, Banks are likely to:
*** Take a deeper look at the sectors they serve to manage their internal concentration lending caps more closely.
*** Become more selective on how and with whom they deploy capital to achieve optimal returns.
*** Apply higher reserves for loan losses.

Thereby ultimately leading to lower lending capacity and/or risk appetite. 

Why does that matter?
Many argue that the additional increase in Tier 1 capital requirements was a reactive response to the three large bank failures (SVB, First Republic, Signature), which exposed gaps for banks in the $100-250 billion asset range. 

However, whether we like to admit it or not, a bailout took place again, which is usually ultimately funded by taxpayers and the government printing more money. The bailout this time was in the form of (i) the bank term funding program (which is coming to an end in 3-2024), (ii) purchase of distressed debt, and (iii) the decision to guarantee all accounts above the $250,000 federal deposit insurance limit. Even though per the FDIC the costs for the bailout will be covered by a special assessment on its member banks and not taxpayers, one could argue such costs will be ultimately passed on to bank clients and the American consumer. 

The consequences of not acting could have been worse, so I am not here to judge whether this was right or wrong as the solution is not simple at all. 

However, the added capitalization requirements, while having negative consequences in the short run should better position mid-tier banking institutions to absorb unexpected exogenous shocks and hopefully avoid more bailouts in the future. 

What does this mean for real estate investors and what are we doing to prepare?
*** Access to capital will be even more important with expected increase in deal flow in 2024-2025.
*** Having multiple lending options and strong lending relationships with proven ability to close on loans.
*** Tapping into other sources of capital such as private lending, creating financing, debt funds, etc..
*** Not levering up too high, in order to have flexible exit strategies in the event of a needed refi or transition to a new lender.

➡️ What are your initial reactions to the news? How is the sponsor you are investing with prepared for the upcoming liquidity crunch? How are you prepared as an operator/syndicator? 


Deja Vu?

Source: CRE Daily

Top largest mortgage originators

Source: CRE Daily

Lending volume is already down, partly due to lower deal flow and partly due to internal bank policies shifting

Source: CRE Daily

Sources: Federal Reserve, Trepp Inc.

Deposits are fleeing to larger financial institutions viewed as more stable and secure

Term funding program utilization year to date continues to increase. What happens after 3-2024?