Fed puts more emphasis on commercial real estate in 2017 stress test

WASHINGTON (Reuters) - The Federal Reserve is putting a bigger focus on commercial real estate in its annual “stress test” of how well the largest U.S. banks would fare in another financial crisis.

A police officer keeps watch in front of the U.S. Federal Reserve building in Washington, DC, U.S. on October 12, 2016. REUTERS/Kevin Lamarque/File Photo

On Friday, the Fed publicly released a broad description of criteria for the 2017 test, and gave lenders until April 5 to submit their results, which will be released in June.

The scenarios outlined in the test came on the same day President Donald Trump is expected to issue an executive order to review banking law introduced in the wake of the 2008 crisis that required the stress test and other tough financial regulations.

The 2017 exam imagines a sudden shock in which the U.S. unemployment rate rapidly soars to 10 percent, with stocks plunging and major global economies facing sharp declines in output.

The hypothetical U.S. downturn is more severe than in the 2016 scenario, and includes a larger decline in commercial real estate prices, the Fed said.

Low interest rates have already pushed banks towards long-term investments like multifamily housing and commercial real estate that can deliver higher yields.

Bank regulators have become increasingly concerned about the industry’s exposure to those loans, and worry that banks have loosened underwriting standards too much. The Office of the Comptroller of the Currency in particular has flagged CRE as a risk.

The most heavily concentrated commercial real estate exposure though lies with community and regional banks that are not subject to the stress test review.

If banks do not prove that they can weather the hypothetical downturn, the Fed may freeze payouts to investors or halt business investment plans until they boost capital reserves.

The Fed performed its first stress test in the aftermath of the 2008 financial crisis to ensure that banks had enough capital to survive. The published results gave investors more confidence in the financial system.

The test was formalized in the 2010 Dodd-Frank reform legislation, which was intended to prevent a future financial meltdown, and the taxpayer bailouts that ensued. President Donald Trump and some leading Republicans in Congress have said they intend to tear up those rules and perhaps replace them.

Only the largest 13 banks are subject to the full stress test this year. Another 21 lenders have to answer a narrower set of questions, excluding tests of internal controls and planning, after complaints that the stress test was too costly and burdensome for smaller banks.

The biggest banks subject to the full exam this year are JPMorgan Chase & Co JPM.N, Bank of America Corp BAC.N, Citigroup Inc C.N, Wells Fargo & Co WFC.N, Goldman Sachs Group Inc GS.N, Morgan Stanley MS.N, U.S. Bancorp USB.N, Capital One Financial Corp COF.N, PNC Financial Services Group Inc PNC.N, Bank of New York Mellon, State Street Corp STT.N and U.S. divisions of HSBC Holdings PLC HSBA.L and Toronto-Dominion Bank TD.TO.

Reporting By Patrick Rucker in Washington and Dan Freed in New York; Writing by Lauren Tara LaCapra; Editing by Chizu Nomiyama and Clive McKeef