CRE Finance World Autumn 2015
8
3. Cyclical Trends Mask the Full Impact of New Regulation
CRE investment and property performance trends have improved
markedly since the economy’s financial crisis-era nadir. With
respect to asset prices, these improvements reflect the strong
relationships between capital markets and CRE investment. There
is a similar relationship between macroeconomic conditions and
property fundamentals, which have lagged capital during the
recovery. With investment and fundamentals now both improving,
CREFC members observe that strong cyclical trends are masking
the drags on commercial real estate finance resulting from current
and pending regulatory reforms. The full cost of reform, and its
impact on real estate market liquidity, may be more readily observable
during phases of the cycle characterized by economic and financial
stress and reduced liquidity.
4. New Regulation Can Reduce Higher-Regulated
Institutions’ Competitiveness
As the cost of financing increases for prudentially regulated
institutions, the relative cost of financing declines for non-bank
financial institutions (NBFIs). Reflecting this relative change,
many CREFC members expressed concern that large, low-risk
borrowers may migrate from banks to other, more competitive
sources of capital, thereby reducing the average quality of banks’
mortgage portfolios.
While lower aggregate lending by banks and SIFIs will reduce
their risk profile, this adverse selection works in the other direction,
increasing the average risk profile. The impact on the total risk
in the market is ambiguous, contrary to the original policy goal.
5. New Regulation Imposes Greater Costs on Small and
Medium-Size Borrowers
The incidence of higher regulatory cost — who ultimately bears
the cost of regulation — will fall to both lenders and borrowers.
In secondary and tertiary markets, small regional and community
banks are often the only consistent sources of construction and
shorter-term financing. Even as smaller banks bear a relatively
higher regulatory burden than larger banks and NBFIs, several
CREFC members observe that smaller borrowers will internalize
a larger share of those increased borrowing costs.
The large drop in secondary market liquidity that coincides with
and follows a downturn places stress on asset values and slows
price discovery. Contrary to policy goals, constraints on smaller
lenders that reduce market liquidity may exacerbate loss rates
and severities for investors and lenders alike.
6. Ambiguous Link to Loan Quality
CREFC members and researchers are divided on the question of
whether current regulatory initiatives will induce higher average
loan quality. Several CREFC members expressed that with greater
demands on finite balance sheets, banks and other regulated
entities will make better lending decisions.
Others market participants observed that when lenders internalize
the costs of regulation, they will need to meet higher return
requirements, which in turn will drive riskier behavior. Alternatively,
if lenders push costs to the borrower, i.e. the incidence of the
lending costs falls to the borrower, better borrowers can substitute
into another financing source. Either way, the regulated loan pool
can deteriorate given higher costs.
7. Impacting the Economy through CRE
The overall impact of new regulation on the CRE industry and
its adjacencies — including construction activity, construction
employment and the broader economy — is significant. In the
median scenario tested by CREFC, the model estimates show a
cumulative subtraction from economic output of $209 billion over
10 years. Across scenarios, the estimated ten-year cost ranges
from $168 billion in the low impact scenario to $936 billion in
the extreme downside case where construction activity declines
by more than 5 percent from baseline projections. The primary
channels of spillovers from regulatory reform are distortions to
asset prices in the presence of costlier leverage and, over the
medium- and long-term, a reduced supply of real property. Apart
from reduced construction activity, a lower inventory of real property
implies that firms will face higher costs in the space market.
Click Here to Share Comments on this ArticleCREFC Regulatory Impact Study: Besides the Financial Costs, Regulation Impacts Business Strategy and Underwriting Criteria
“Fragmentation of regulatory authority
has allowed for parallel — and sometimes
overlapping — regulatory initiatives.”