Commercial property puts banks at risk

OVER-EXPOSURE to the commercial property sector could pose a serious risk to British banks, which will need to shore up their balance sheets substantially over the coming years, the Bank of England will warn in its biannual Financial Stability Report (FSR).

Commercial property has been seen as one of the most toxic sectors and outstanding loans to the sector exceeded £250bn in September. Values have dropped almost 45 per cent since their June 2007 peak, pushing some loans into negative equity – the Property Industry Alliance estimates average loan-to-values could reach 114 per cent by the end of 2010, putting the average loan into negative equity.

The Bank believes that deteriorating macroeconomic conditions appear to have significantly increased the probability of default by UK real estate companies, which could be triggered by falling rental values and the scheduled £160bn refinancing of loans over the next five years. Should these risks materialise, the Bank envisages substantial impairments beyond the high seven per cent rate recorded by major UK banks in the first half of the year.

Although banks’ core Tier One capital ratios are now at pre-crisis levels of 9.6 per cent, the Bank says financial institutions must increase their capital equity buffers substantially to protect themselves from commercial property exposure and other potential destabilisers – including the need to refinance £1 trillion worth of wholesale funding by 2015.

Given that banks will face higher capital requirements on trading assets and securitisations from 2011, the FSR urges banks to take the opportunity to strengthen balance sheets by reducing leverage, extending the maturity of funds so they are not dependent on short-term money and repaying public sector support.