WASHINGTON — Bank regulators warned Wednesday of continuing credit- and asset-quality declines, particularly for commercial real estate loans.

Speaking at a Senate Banking subcommittee hearing on the state of the banking industry, the regulators overwhelmingly saw commercial real estate as their biggest worry.

"The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending," Federal Deposit Insurance Corp. Chairman Sheila Bair said. "While financing vehicles such as commercial mortgage-backed securities have emerged as significant CRE funding sources in recent years, FDIC-insured institutions still hold the largest share of commercial mortgage debt outstanding, and their exposure to CRE loans stands at an historic high."

The hearing occurred as the House Financial Services Committee began debating the first bills designed to revamp the regulatory structure. Sen. Tim Johnson, the financial institutions subcommittee chairman, warned lawmakers not to lose sight of the existing problems for banks as they focus on regulatory reform.

"While restructuring our nation's regulatory system is this committee's top priority, I don't think we can do that without a clear understanding of what is happening within the sector," Johnson said. "Concerns and problems within individual financial institutions will still exist even with a new regulatory structure."

Regulators said community banks face the most exposure to potential CRE losses. And as of June, CRE loans backed by nonfarm, nonresidential properties totaled almost $1.1 trillion, or 14.2% of total loans and leases, according to the FDIC.

The Office of Thrift Supervision reported that business bankruptcies increased 64% in the first half of the year, the highest rate of increase in 16 years.

Federal regulators issued guidance on CRE loans in 2008 and will soon issue guidance on modifications to such loans. Large volumes of CRE loans are scheduled to roll over in coming quarters. Federal Reserve Board Gov. Dan Tarullo said $500 billion of CRE loans will need to be refinanced this year and next.

"That creates a set of challenges that are no more serious but different from the case with residential mortgages," Tarullo said.

CRE loans also have contributed to a number of the bank failures this year, which total 98. Regulators said they expected more failures to come. "We expect the numbers of problem institutions to increase and bank failures to remain high for the next several quarters," Bair said.

Comptroller of the Currency John Dugan cited problems throughout asset types.

"Despite early signs of the recession ending, credit quality is continuing to worsen across almost all classes of assets in banks of almost every size," he said. "While we are seeing some initial signs of improvement in some asset classes as the economy begins to recover, it will take time for problem credits to work their way through the banking system, because credit losses are often behind the return to economic growth."

He also encouraged banks to continue to increase their capital and reserves for future losses, but warned it may not be enough.

"In some cases that may not be possible, however, and as a result, there will continue to be a number of smaller institutions that are not likely to survive their mounting credit problems," he said. "Given the real estate concentrations in community banks, the number of problem banks, the severe problems in housing markets and increasing concern with CRE, we expect more bank failures in the months ahead."

With the expected bank failures to come, Bair touted her proposal of raising $45 billion from banks' prepayments of premiums to pay insured depositors and cover resolution costs.

"Prepayment would not materially impair the capital or earnings of insured institutions," Bair said. "In addition, the FDIC believes that most of the prepaid assessment would be drawn from available cash and excess reserves, which should not significantly affect depository institutions' current lending activities."

She said prepayment is preferable to borrowing from the Treasury Department because it ensures the Deposit Insurance Fund is directly funded by the industry and it would not count against the public debt.

Asked by lawmakers whether the regulators could support a plan touted by Senate Banking Committee Chairman Chris Dodd to merge the regulators into one, several said they opposed the idea.

"We are concerned about it," Bair said. "We fear it will weaken the FDIC and the overall economic condition."

Joseph Smith, the commissioner of banks for North Carolina, added that the Conference of State Bank Supervisors opposes "it from the tops of our heads to the bottoms of our feet."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.