T
he US banking system remains stable, but concerns are growing over commercial real estate loans. The Federal Reserve's latest supervision report highlights a significant spike in office loan defaults, with the delinquency rate at 11% for large banks - a worrying trend given the sector's historically stable nature.

    While overall banking sector strength is evident, with most institutions reporting robust capital levels and over 99% considered "well capitalized," commercial real estate has seen its highest delinquency rates since 2014. Large banks have borne the brunt of office loan deterioration so far, but warning signs are emerging for smaller institutions, which typically hold a higher proportion of their assets in commercial real estate loans.

    The commercial real estate sector's troubles extend beyond office space, with multifamily properties also experiencing stress due to slowing revenue growth and rising operating costs. Banks have been building defenses by adding credit loss reserves, particularly in commercial real estate and consumer lending sectors.

    Despite the banking system's overall liquidity stabilizing since 2023, persistent and worsening stress in commercial real estate suggests structural rather than cyclical challenges. The Fed has intensified its scrutiny of commercial real estate, listing it as a key supervisory priority and promising close monitoring of banks with concentrated exposure to office and multifamily lending.

    Smaller banks are now showing signs of strain, and property valuations are under pressure, making the commercial real estate sector a significant test for the banking system's resilience in the months ahead. Consumer credit also shows cracks, with delinquency rates remaining elevated compared to historical levels, particularly in credit card defaults and auto loan delinquencies.

    The deposit landscape has shifted, with uninsured deposits declining to levels last seen in 2019, suggesting a more stable funding environment. However, banks' responses have diverged by size, with larger institutions increasingly turning to wholesale funding sources while smaller banks reduce their reliance on such funding.

    Bank earnings have demonstrated resilience, with return on assets and return on equity improving in the first half of 2024. Net interest margins stabilized in the second quarter, and noninterest income has helped support overall profitability. The Federal Reserve's report reveals an intensified focus on several key areas of risk, including cybersecurity threats and governance and controls.

    Looking ahead, while the banking system remains fundamentally sound, ongoing challenges in commercial real estate and consumer lending segments suggest that these areas will remain key focuses of supervisory attention as the sector navigates a period of structural change.