Small banks are feeling misunderstood.
They see themselves as integral to neighborhoods across the country: backers of local dry cleaners, dentists and sandwich shops. Investors worry that those banks could be a crisis waiting to happen.
The pride and the anxiety both reflect the fact that community banks are big lenders in the commercial real-estate market, which has been rocked by falling property values as large office buildings sit empty.
But executives at these firms — which number about 4,100 in total — say there is an important distinction, and some industry analysts concur. They caution that small banks are being lumped in with lenders to the owners of half-empty towers in Manhattan, San Francisco and Chicago, which are in the most trouble.
Instead, a majority of commercial building loans by community banks are for smaller buildings — like those housing doctors and local businesses — that tend to be fully leased. And while there are concerns about financial pressure on apartment building landlords if interest rates remain high, missed payments on those types of mortgages have not risen substantially.
“The focus has been on office as that is the weak category,” said John Buran, the chief executive officer of Flushing Financial, based in Uniondale, N.Y., which operates branches as Flushing Bank in Queens, Manhattan and Brooklyn and on Long Island. “Most community banks don’t have the type of exposure.”
Mr. Buran said loans to office building landlords were 4 percent of Flushing Financial’s portfolio, compared with roughly 38 percent for loans to apartment building owners. All of its loans are performing well, he said. But its stock, at about $16.20 a share, is slightly lower for the year — even after a sharp rally this month.
Shares of other small lenders have lagged behind stocks of big banks and the broader market this year. Regulators are watching them closely after being burned last year by the unexpected failure of three larger regional banks. Even if small banks are sound right now, there is unease over what may happen if there is a surge in loan defaults.
Nearly 40 percent of the $3 trillion in commercial real-estate loans held by banks are in small institutions — those with less than $15 billion in assets — according to S&P Global Market Intelligence. Regulators consider it a warning sign when a bank’s commercial real-estate loan portfolio is more than 300 percent greater than the capital required to cover its financial obligations during a crisis. Roughly 400 small banks currently exceed that threshold, according to S&P.
Many small banks routinely operate with loan exposures beyond the regulatory threshold because they depend heavily on lending to generate revenue, said Nathan Stovall, the director of financial institutions research for S&P Global Market Intelligence. But Mr. Stovall said banks weren’t getting credit for prudent lending.
“You are having a lot of investors with a shoot-first mentality,” he said. “Not all commercial real estate is created equal.”
Flushing Financial, with $9 billion in assets, is among the banks that have exceeded the threshold. Its commercial real-estate portfolio is around 477 percent of its risk-based capital, according to S&P Global Market Intelligence.
Mr. Buran acknowledged this, but said the metric didn’t reflect the bank’s loan quality.
“The devil is in the details,” he said. “We are very careful about our growth and conservative about our lending.”
There has been one bank failure this year: Republic First Bancorp, a community bank based in Philadelphia that had $6 billion in assets, including $1.7 billion in commercial real-estate loans. And the trouble that struck the banking sector a year ago — and led to the failures of First Republic Bank, Silicon Valley Bank and Signature Bank, with over $100 billion in assets among them — wasn’t directly caused by alarm over commercial real-estate loans. It was prompted by a drop in the value of the banks’ own investments, a result of rising interest rates and the high percentage of customers with uninsured deposits who panicked and pulled their money out.
Some small banks have taken steps to shore up their capital.
First Foundation, a bank based in Dallas with $13.6 billion in assets, announced this month that it had raised $228 million by selling shares at a steep discount to a group of big investment firms, including Fortress Investment Group. The bank, which has 30 branches in five states, said it planned to use the additional capital to increase its loan loss reserves. It also said it would sell off some of its large portfolio of loans to apartment building landlords.
Scott F. Kavanaugh, the chief executive of First Foundation, said on an investor call that the move to raise capital had not been prompted by regulatory considerations, but that it had been the “prudent thing to do.”
Before then, First Foundation’s commercial real-estate portfolio was roughly 500 percent of its risk capital, according to S&P Global Market Intelligence. Shares of First Foundation plunged after the announcement but have recovered those losses and are now trading slightly higher.
Some analysts say there are reasons to remain watchful, especially if the economy falters. Bank regulators, in particular the Office of the Comptroller of the Currency, are looking at community banks and small regional lenders to make sure those institutions are moving to reduce their overall loan exposure or are raising more capital to cover any losses.
The comptroller’s office sees little downside in taking an aggressive approach with the small banks, said Doug Landy, who is the co-head of the financial institutions practice at White & Case, a law firm based in New York.
“The O.C.C. and the other regulators are looking at this and saying, ‘Let’s prepare for a bad situation in the future and if it doesn’t happen, no harm, no foul,’” he said.
The O.C.C. scrutiny is particularly evident when community banks seek to merge. One response has been to sidestep the regulator.
In April, FirstSun Capital, which is based in Denver, said that it was becoming a Texas-chartered financial institution and that it would no longer be regulated by the O.C.C. The bank said the switch was necessary to speed up the completion of its planned merger with HomeStreet Bank, based in Seattle, which has a heavy concentration of commercial real-estate loans.
Neal Arnold, the C.E.O. of FirstSun, said the bank decided to undertake the regulatory shift after conversations with the comptroller’s office. “The O.C.C. was not going to approve this deal anytime soon,” he said.
Stephanie Collins, an O.C.C. spokeswoman, said the regulator “examines banks on a case-by-case basis to ensure their risk management practices are appropriate.”
Patricia A. McCoy, a professor at Boston College Law School who focuses on financial services regulation, said FirstSun’s move could inspire other community banks considering deals to do the same.
But she said the O.C.C. was right to look at how small banks were handling high concentrations of commercial real-estate loans. The concern is that investors and depositors will smell weakness in banks that are not moving fast enough to address the issue — setting off another crisis in which trouble at one bank spreads across the industry.
“What we worry about is contagion,” Ms. McCoy said. “Right now, regulators are in a watch-closely mode.”
Susan C. Beachy contributed research.