CREFW-Summer2015

34 / 72

CRE Finance World Summer 2015
32
uring the crisis, the regulators aimed for model accuracy
as their guideline toward normalization of the marketplace.
To jump start the process, regulators applied stress tests
to aid in price discovery and to rebuild capital. They also
set about developing Basel III to permanently close off
regulatory capital arbitrage loopholes identified in the crisis.
Their thesis was that first, if everyone could agree on the fundamental
value of an asset then, where necessary, troubled assets could
be cleared through the system. Secondly, if more sensible capital
charges could be assessed, then the public’s confidence could be
restored in critical financial institutions.
While not the source of contagion in this latest cycle, commercial
real estate (CRE) assets were treated with especial vigor. The
stress tests forced relatively aggressive revaluations of legacy CRE
assets, and risk-based capital reforms are encouraging capital
levels permanently higher along a number of dimensions.
And yet, the Financial Stability Oversight Council (FSOC) and the
Office of Financial Research (OFR) have never outed CRE as a
source of systemic risk. Each of these bodies publishes an annual
report, which is really more of a review of accomplishments during
the year combined with a risk assessment of the global markets.
None of these reports, at least not as of their most recent, the
OFR’s December 2014 annual, suggests that the CRE sector
poses a threat to financial stability.
Considering that our European counterparts take a very dim view
of CRE, it is interesting to note that for the U.S. regulators, one
of CRE’s minuses may be protecting it from a systemic risk label.
Unlike other traded credit classes, CRE products resist product
standardization, and therefore are limited in the degree to which
they can be integrated into faster-paced trading strategies.
Other product sets that are more actively traded have attracted
a considerable amount of attention from the regulators.
From a systemic risk perspective, CRE debt’s idiosyncratic nature
can be viewed as a strength. If all of our financial products were
standardized enough to be actively bought and sold, then the
system as a whole would be relatively more exposed to herding
behavior. By this measure, CRE represents a stabilizing influence,
because our investors can be counted upon to be somewhat less
reactive in bad times.
But, enough is often not enough. In their April 6, 2015 Liberty
Street Blog post, members of the New York Fed’s Research and
Statistics Group made the case that over time, the stress tests are
yielding some convergence between regulatory and bank models.
This would be expected, as banks would naturally try to anticipate
their supervisors’ requirements in order to pass the tests. However,
according to this recent analysis, the two sides remain farther apart
still on net charge-off estimates, and especially those related to CRE
loans. That’s not good news for commercial real estate lending.
Chart 1
Breakdown in Differences in Net Charge-Off Projections
Source: Authors’ calculations
On the surface of things, variance between the regulatory and the
industry models can suggest poorly quantified risk-taking on the
part of the banks. Potential model inaccuracies gained attention
well before this spring with earlier analyses by the Basel Committee
on Banking Supervision (BCBS). As part of their efforts to further
refine Basel III, the BCBS has run a series of analyses of bank
capital estimations over time to learn more about bank practices.
At least on the surface, the BCBS has found that despite the
rollout of Basel III, many jurisdictions continue to view capital
requirements differently. Looking below the surface, however,
these differences do not necessarily mean anything other than
the portfolios in question might not be as similar as we think.
To determine whether model variances are a sign of accuracy or
of aggressive risk-taking, further work needs to be done. A model
used to estimate capital requirements for a CMBS portfolio in
the U.S. may act differently than a model used to estimate capital
for CMBS in Italy. Both models could be equally robust, yet the
underlying risks are very different, which could explain even large
variances in capital requirements.
Nuances in product type, market functioning, legal system, and
other factors could easily account for differentials in model output
across banks and especially across jurisdictions. Concluding
that these variances are a sign of problems with the models may
be ignoring valid differences in portfolio fundamentals, and the
regulators may be promoting conservatism over accuracy. Yet, the
D
Christina Zausner
Vice President, Industry
and Policy Analysis
CRE Finance Council