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FRANKFURT, Jan 25 (Reuters) – The European Union’s risk watchdog warned on Wednesday that market stress from a possible sharp downturn in Europe’s commercial real estate sector could translate into systemic risk for banks, leading to greater capital needs.

Supervisors have long warned that the bloc’s real estate market was in a turning point after a long boom, and commercial property was particularly vulnerable as the cyclical downturn was exacerbated by changes in post-pandemic office use habits.

The European Systemic Risk Board has now issued a new directive to national and European Union authorities to monitor risks and force lenders to properly value collateral, setting aside the relevant provisions.

“The sector is currently vulnerable to cyclical risks related to rising inflation, tightening financial conditions that limit the ability to refinance existing debt and take on new loans, and a marked deterioration in the growth outlook,” the ESRB said in a statement.

Climate-related economic policies such as changing building standards, the shift to e-commerce and increased demand for flexibility in leased office space are adding to the pressures, said the ESRB, which is chaired by European Central Bank President Christine Lagarde.

The recommendations come after the ESRB issued a warning in September about rising default risks in commercial real estate.

The concern is that a sharp downturn in the sector could have a systemic impact on the financial system and the wider economy, limiting banks’ lending capacity.

Lending to the sector is carried out at a high loan-to-value ratio, which may increase further if property valuations rise. That would then lead to higher provisioning and capital requirements, limiting banks’ ability to lend to others, the ESRB said.

An additional concern relates to liquidity inconsistencies in real estate investment trusts, the ESRB added.

Therefore, funds should better match maturity terms and liquidity of underlying assets and should assess risks arising from liquidity mismatches and leverage, it added.

Reporting by Balazs Korani; Editing by Emelia Sithole-Matarize

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