(Bloomberg) -- The European Central Bank is signaling to lenders that they may face higher capital requirements if they have an insufficient handle on risks they face from commercial real estate, according to people familiar with the matter. 

The watchdog is placing greater emphasis on the management of commercial property risks, in a dialog with banks that comes before the annual bar for their financial strength is set, said the people, who asked to remain anonymous as the discussions are private. 

While individual requirements would probably only apply next year, senior officials view the early warnings as a way to limit losses from the asset class.

An ECB spokesman declined to comment. The watchdog has said that addressing banks’ shortcomings in credit risk management is one of its top priorities.

Commercial real estate markets have been in a sharp decline as last year’s spike in interest rates compounded challenges from the shift to work-from-home and changing retail behavior. The ECB has scrutinized banks’ lending practices for several years and has repeatedly faulted them for taking too much risk, including in December when it cited evidence that lenders were over-valuing collateral.

The latest escalation follows pressure from the ECB last year that the people familiar with the matter say contributed to banks booking higher provisions for possible losses on commercial real estate. Senior officials say that while the ECB’s intensity hasn’t changed, the materialization of losses means the watchdog’s approach is evolving.

What Bloomberg Intelligence Says:

Real estate distress is causing shockwaves at select lenders — from NYCB in the Americas to Aozora in Asia and Julius Baer and Deutsche Pfandbriefbank in EMEA — but the rot doesn’t look global or systemic. However that’s thin comfort with office landlord bonds no longer riding high. Sector fundamentals, though not especially concerning, may offer limited reassurance. Provisioning could rise, dampening profit and denting capital.

-Tolu M Alamutu, BI Senior Credit Analyst

CRE Bank Loan Apocalypse? Maybe Not, But This Is Going to Hurt

The officials Bloomberg spoke to say they don’t expect the troubles in the commercial real estate market to result in a significant hit to banks’ capital ratios. They view the pressure on banks’ risk management as a way to limit the damage.

The ECB wants to ensure that banks “are doing look-through credit analysis,” especially given the change in interest rates, Elizabeth McCaul, a member of the ECB’s Supervisory Board, said last month. Banks have been “slow” to re-assess real estate loans as being riskier, she said at a conference in Frankfurt.

Investors have been focused on the risks banks face from US commercial real estate, which has seen some of the steepest declines in valuations. In the US, the KBW Regional Banking Index has slumped more than 10% since New York Community Bancorp last week announced a surprise loss tied to deteriorating credit quality, spooking investors in other banks including Valley National Bancorp.

In Germany, Deutsche Pfandbriefbank AG saw its bonds and shares hammered this week over concerns about its exposure to the US, in a sign that the troubles are spreading to Europe. 

On aggregate, European banks already face a higher bar for their financial strength this year. That’s largely because national regulators have ordered them to build buffers to weather an economic downturn. A requirement set by the ECB that feeds into the minimum level rose only slightly overall, albeit with jumps for certain lenders. 

The ECB slapped Pfandbriefbank with the single highest increase in its capital requirements for individual banks last year. The firm didn’t explain why, yet said in December that it’s “well above” what’s required of it.

French and German banks have the most commercial real estate loans in the European Union, according to data from the European Banking Authority for the third quarter. Earlier analysis from the European Systemic Risk Board, a fellow watchdog, shows banks in Germany have the highest share of cross-border commercial real estate exposure among banks from the bloc’s major economies.

Germany and Austria are also the epicenter of the euro area’s most prominent commercial real estate blow-up so far, the collapse of tycoon Rene Benko’s Signa group of companies.

The ECB has been criticized by some bankers for what they say is a hand in the demise of Signa. The ECB has pushed back against that characterization, with its former top supervisory official calling it “bizarre” given it is the central bank’s job ensure lenders deal with risks.

(Adds detail on regional banks from ninth paragraph.)

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