Financial Risk Heightens Amid ‘Extend and Pretend’ Practice by Banks
A recently released paper by the Federal Reserve Bank of New York shows that weakly capitalized banks’ “extended-and-pretended” policy for “their impaired CRE mortgages in the post-pandemic period to avoid writing off their capital,” has led to “credit misallocation and a buildup of financial fragility.” Furthermore, new credit provision has been crowded out, leading to a “4.8-5.3% drop in CRE mortgage origination since 2022:Q1 while also fueling the amount of CRE mortgages maturing in the near term, which as of 2023:Q4 represents 27% of bank capital, creating a heightened “risk of large losses materializing in a short period of time.” Partially fueling banks’ incentive to extend maturities, which is particularly pronounced from 2022:Q1 onward, was the rapidly rising rates that “created large market-to-market losses on securities (losses generated through an accounting entry rather than the actual sale of a security or other asset) held by banks, eroding their economic capital.” This type of accounting entry “makes [banks] more likely to be monitored by regulators and credit rating agencies and, ultimately, makes them vulnerable to runs by uninsured depositors.” Should the maturity extensions “mechanically fuel a rising wave of impaired loans in the future,” the potential of defaults becoming widespread with banks incurring sudden and extensive losses will depend upon “whether banks will be able to deal with rising defaults in an orderly fashion.”
Source: https://www.newyorkfed.org/research/staff_reports/sr1130