by Calculated Risk on 4/17/2008 09:56:00 AM

From Fed Vice Chairman Donald L. Kohn: The Changing Business of Banking: Implications for Financial Stability and Lessons from Recent Market Turmoil

Setting aside the 100 largest banks, the share of commercial real estate loans in bank loan portfolios nearly doubled over the past 10 years and is approaching 50 percent. The portfolio share at these banks of residential mortgage and other consumer loans, which are more readily securitized, fell by 20 percentage points over the same period.

This is a key point that we've discussed before - the small to mid-sized institutions were not overexposed to the housing bubble because those loans were mostly securitized. Therefore the housing bust led directly to only a few small bank failures over the last couple of years.

However, these same banks have a heavy concentration in commercial real estate (CRE) loans, and also in construction & development (C&D) loans. Now that CRE is weakening - and the C&D loans are coming due - there will probably be a sharp increase in bank failures over the next couple of years.

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.