The numbers are staggering. Over the next three years, $2.2 trillion in commercial real estate loan payments are due, with more than $1 trillion in CRE loans coming due in the next two years alone, and an increasing number of banks, mostly regional and community banks, risk having insufficient capital cushions. For context, banks have about $3 trillion of their assets invested in commercial real estate loans, which is double what they had in 2012.

This concentration represents more than just portfolio risk—it reflects the fundamental business model of community banking. Local banks have deep relationships with commercial borrowers, specialized knowledge of regional markets, and limited opportunities to diversify geographically. When commercial real estate markets turn, these institutions cannot simply shift their focus to other asset classes or markets.

The Extend-and-Pretend Epidemic

Recent research from the Federal Reserve Bank of New York has revealed the troubling prevalence of “extend-and-pretend” practices across the banking sector. As of 2023:Q4, this “maturity wall” represents 27 percent of bank capital, indicating that more than a quarter of banking system capital is tied up in loans that should have matured but have been extended to avoid recognizing losses.

The mechanics of extend-and-pretend are deceptively simple: when a commercial real estate loan matures and the borrower cannot refinance or repay, the bank extends the maturity date rather than foreclosing and recognizing the loss. This allows the bank to continue accruing interest income, avoid provisioning for losses, and maintain regulatory capital ratios. Extend-and-pretend has caused a 4.8% to 5.3% drop in CRE mortgage origination since the first quarter of 2022, as banks focus on managing existing distressed assets rather than originating new loans.

For community banks, this strategy is particularly attractive because it avoids the immediate capital hit that could trigger regulatory intervention or threaten their survival. Unlike large banks with diverse revenue streams and robust capital buffers, community banks often lack the financial flexibility to absorb significant losses without jeopardizing their franchise value.

The Domino Effect Mechanism

The extend-and-pretend strategy creates a dangerous coordination problem across the community banking sector. Individual banks, acting rationally to preserve their own solvency, collectively build a “maturity wall” of deferred losses that grows larger and more precarious over time. “The possibility of a large and sudden capital hit for banks becomes more likely as the maturity wall becomes taller”.

This dynamic creates several interconnected risks:

Synchronized Failure Points: When external pressures finally force banks to recognize losses—whether from regulatory pressure, depositor runs, or funding stress—multiple institutions may hit their breaking points simultaneously. Unlike the staggered failures that characterize normal credit cycles, the extend-and-pretend strategy creates artificial synchronization that amplifies systemic risk.

Local Credit Market Paralysis: Community banks that become distressed or fail do not have ready substitutes in local markets. When a regional bank that has extended $100 million in commercial mortgages suddenly stops lending, that capacity cannot be quickly replaced by online lenders or large banks unfamiliar with local markets. The result is an immediate contraction in credit availability for local businesses, municipalities, and developers.

Depositor Flight Amplification: Community banks rely heavily on local depositors who may have personal relationships with borrowers and intimate knowledge of local real estate markets. When news of CRE distress spreads through tight-knit business communities, it can trigger rapid deposit outflows that force immediate asset sales and accelerate the recognition of losses.

Regulatory Cascade Effects: State banking regulators, who oversee most community banks, lack the resources and tools available to federal regulators. When multiple banks in their jurisdiction face simultaneous distress, state regulators may be forced into reactive mode, potentially triggering examination downgrades and enforcement actions that further destabilize local banking markets.

Beyond Individual Bank Risk: Systemic Implications

The community bank domino effect poses risks that extend far beyond the banking sector itself. These institutions serve as critical financial infrastructure for local economies, and their simultaneous distress can trigger broader economic disruption.

Small Business Credit Crunch: Community banks originate a disproportionate share of small business loans, often based on relationships and local knowledge that cannot be easily replicated by larger institutions. When multiple community banks simultaneously reduce lending or fail, small businesses lose access to credit precisely when economic conditions are already challenging.

Municipal Finance Disruption: Many municipalities rely on local banks for operational credit lines, equipment financing, and infrastructure loans. The failure or distress of community banks can leave local governments scrambling for alternative financing sources, potentially forcing delays in essential services or infrastructure projects.

Real Estate Market Dysfunction: In smaller markets, community banks often serve as the primary source of commercial real estate financing. When these lenders simultaneously withdraw from the market, property values can collapse more severely than fundamental economic conditions would suggest, creating negative feedback loops that worsen bank loan losses.

The Regulatory Blind Spot

Current banking supervision frameworks are poorly equipped to address the community bank domino effect. Federal regulators focus primarily on systemically important institutions, while state regulators often lack the resources and analytical tools to identify emerging systemic risks within their jurisdictions.

The problem is compounded by the fact that community banks’ CRE exposures are often concentrated in specific property types or geographic areas that do not appear risky in isolation. A community bank with a heavy concentration in healthcare properties, for example, may appear well-diversified compared to a bank focused solely on office buildings. However, when healthcare real estate faces sector-wide challenges—such as changes in reimbursement policies or shifts toward outpatient care—multiple seemingly unrelated banks may face simultaneous distress.

Furthermore, the extend-and-pretend strategy makes it difficult for regulators to assess the true health of community bank CRE portfolios. Traditional examination procedures focus on current performance metrics, but may not adequately capture the risks embedded in modified and extended loans. This creates a false sense of security that persists until external pressures force rapid recognition of accumulated losses.

Policy Implications and Recommendations

Addressing the community bank domino effect requires a multi-faceted approach that recognizes both the unique risks these institutions face and their critical role in local economies.

Enhanced Stress Testing for Community Banks: Regulators should develop stress testing frameworks specifically designed for community banks with significant CRE exposures. These tests should model scenarios where multiple local banks face simultaneous distress, rather than treating each institution in isolation. The scenarios should also account for the limited liquidity and market depth that characterizes many regional commercial real estate markets.

Improved Disclosure and Transparency: Community banks should be required to provide more detailed disclosures about their extend-and-pretend activities, including the original maturity dates of modified loans, the terms of extensions, and the underlying collateral values. This information would help regulators, depositors, and counterparties better assess the true risk profile of these institutions.

Coordination Between State and Federal Regulators: Given that community banks often serve overlapping markets despite being chartered in different states, regulators need better mechanisms for sharing information and coordinating supervisory actions. A community bank crisis that begins in one state can quickly spread to neighboring jurisdictions through interconnected real estate markets and business relationships.

Proactive Capital and Liquidity Requirements: Rather than waiting for problems to manifest, regulators should consider implementing enhanced capital and liquidity requirements for community banks with high CRE concentrations. These requirements should be calibrated to reflect the additional systemic risk these institutions pose when they act collectively.

Alternative Resolution Mechanisms: Traditional bank resolution procedures may be inadequate for addressing the community bank domino effect. Regulators should develop mechanisms for coordinated resolution of multiple small banks, potentially including regional bridge banks or assisted mergers that preserve critical lending relationships while addressing solvency concerns.

The Path Forward

The community bank domino effect represents a perfect storm of regulatory gaps, economic incentives, and systemic risks that could destabilize local economies across America. Unlike the “too big to fail” problem that dominated post-financial crisis reforms, this challenge involves institutions that are individually “too small to matter” but collectively too important to ignore.

Regional US banks are facing a troubling trend known as “extend-and-pretend,” which is raising concerns about a systemic delay in acknowledging CRE loan distress. The longer this situation persists, the higher the maturity wall grows, and the more severe the ultimate reckoning becomes.

The solution requires recognizing that community banks, despite their small individual footprints, operate as an interconnected system that serves as critical infrastructure for local economies. Regulatory frameworks must evolve to capture these network effects and systemic risks, while preserving the relationship-based lending model that makes these institutions valuable to their communities.

The stakes are clear: The New York Fed warns that regional banks that delay recognizing distress in CRE loan portfolios are creating systemic risks. Without coordinated action from regulators, industry participants, and policymakers, the community bank domino effect could trigger precisely the kind of localized credit crises that broader financial stability depends on preventing.

Time is running short. The maturity wall continues to grow, and the economic pressures that will eventually force recognition of losses are building. The question is not whether the extend-and-pretend strategy will ultimately fail, but whether policymakers will act proactively to mitigate the systemic consequences when it does.