European banks’ exposure to commercial real estate could erode financial stability if the economy is hit by a bigger shock, according to the European Central Bank.

Commercial real estate markets “have the potential to significantly amplify an adverse scenario, increasing the likelihood of systemically-relevant losses being incurred in the banking system,” the ECB said in an excerpt of its financial stability review, which is scheduled to be published on Wednesday in Frankfurt.

Commercial real estate has been one of the assets hit hardest by a rapid increase in interest rates as developers also face lower demand for office space in the post-pandemic era. The industry has also seen a drought of deals for over a year now, making it hard to know whether the values banks record in their loan book are accurate.

About 10% of euro-area banks’ combined loans are exposed to commercial real estate, far smaller than the almost 30% for residential real estate, which has proved less risky so far, according to the ECB.

“A scenario where real estate firms suffer very large losses would likely coincide with stress in other sectors,” the ECB said. “Moreover, a negative outcome of this type would also drive large losses in other parts of the financial system which are significantly exposed to CRE, such as investment funds and insurers.”

--With assistance from Alexander Weber.