ECB Warns ‘Flawed Models’ on Property Loans Threaten Banks
The European Central Bank has issued a caution regarding certain banks' overreliance on deficient models provided by their commercial real estate borrowers, heightening their susceptibility to economic downturns. The ECB's report highlighted notable gaps in these models, particularly when appraising less liquid assets or during significant market downturns. ECB examiners uncovered instances where the outputs from automated valuation models were unreliable for problematic or illiquid assets without further verification.
Amid expectations that traditional banks will need to decrease their exposure to commercial real estate loans—requiring subsequent refinancing by buyers—non-performing CRE loans surged by 12% to approximately €58 billion at the close of 2023. The European Banking Authority, which regulates and supervises banking within the EU, noted that 4.1% of all loans to the sector are now considered non-performing.
The ECB also advised caution to lenders and borrowers optimistic about recovering markets as interest rates drop, given the pervasive issues with property valuations. It found that banks often set "market value" based on the prices they hope to achieve in future sales, rather than the current recoverable value. Throughout the latter half of 2022 and into 2023, inspection teams discovered banks relying on transactional data from 2021 or before. Despite worsening economic conditions, increasing inflation, and rising borrowing costs, banks claimed there was no proof of declining market values without more recent transactional evidence.
The investigations also revealed that banks sometimes provided asset-backed lending without thorough valuations of the underlying properties, and in some cases, this lending was unsecured. Moreover, banks were found using listing prices instead of actual sale prices for valuing comparable properties. With rising interest rates and diminishing demand affecting critical segments, the likelihood of borrowers facing repayment difficulties has increased, making prudent collateral valuation more crucial than ever.
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