The regional banking sector's risk from distress in the commercial real estate industry appears to be larger than previously known, a new analysis found, posing a threat to the wider economy.

Banks in total have roughly $3.6T of exposure to commercial real estate, equivalent to 20% of their deposits, according to an analysis The Wall Street Journal published Wednesday.

Small and midsized banks — those with less than $250B in assets — held about three-quarters of all commercial real estate loans as of the second quarter, the WSJ found.

As fundamentals in some commercial real estate markets erode, banks could face a period of shocks as borrowers default in higher numbers, and the banking pain would further depress CRE — touching off a so-called doom loop scenario.

“The plumbing is clogged right now,” RXR Realty CEO Scott Rechler told the WSJ. “And that is going to create a backup that will eventually overflow on the commercial real estate markets and on the banking system.”

CRE has other sources of capital besides banks, including private debt funds, mortgage REITs and bond investors. The catch is that many of those entities depend on bank loans themselves, and banks have cut back.

During a period of historically low interest rates in the seven years leading up to 2022, banks nearly doubled their direct lending to landlords to $2.2T. Small and midsized banks made up 74% of the increase during that time.

That isn't the entirety of banks' exposure, however, the WSJ reported. Counting loans made to nonbank lenders who serve CRE, as well as purchases of bonds tied to commercial real estate, the paper estimates total exposure at $3.6T.

The potential doom loop formed by banks and CRE could impact much more than those industries, especially if employees remain successful in retaining the remote work patterns established earlier in the pandemic, thus keeping downtown office values depressed.

Downtowns, especially in midsized cities, face permanent contractions as fewer people work there or visit for any other reason, a dynamic that reinforces itself.

“Once those offices are empty, there are few alternatives and not a lot of life after hours,” Stijn Van Nieuwerburgh, who is a professor of real estate and finance at Columbia University, told The Washington Post.