Hundreds of small and
regional banks across the U.S. are feeling stressed. More than 280 banks face the
dual threat of commercial real estate loans and
potential losses tied to higher interest rates. There's no doubt in my mind
there's going to be more bank failures Or at least, dip below their
minimum capital requirements. There will be bank failures. But, this is not the big
banks. Rapid interest rate hikes
can mean borrowers suddenly face more expensive loan
payments, and if they can't afford to pay up, they may
default on their loans. A record $929 billion worth
of loans are coming due, aka maturing in 2024, driven by
"mass extensions" of loans originally due in 2023. Regulators are working
behind the scenes with potentially at-risk
lenders. They're issuing sort of
confidential under the radar reports, saying you got to
raise your capital. We'll see a lot fewer bank
failures than we would otherwise if we're
successful in attracting private capital to
recapitalize these banks These are banks that
probably need to raise capital, or they could try
to get acquired by a stronger bank. However, banking sector
acquisitions have dwindled. These stressed banks could
have big implications for the U.S. economy. It's been one year since the
collapse of Silicon Valley Bank... Of course, we're seeing
cracks form once again a year later. Both major and regional bank
indexes are still struggling since 2023's bank failures. I think most of them are
just fine. But, confidence is
everything in banking. If people start losing
confidence then even the healthy banks can be
adversely impacted. Here's why hundreds of small
banks may be at risk of failure and how insolvency
can be avoided. The U.S. has thousands of
banks. There are about 4,600 banks
in the United States. But in most developed
economies in the world, there aren't regional and
community banks. Approximately 4,000 banks in
the U.S. are small banks, also known
as community banks. If you add up the
collective assets of those 4,000 banks, small banks
control roughly the same value of assets as
America's largest bank, J.P. Morgan Chase, with
$3.2 trillion of assets. Now, the stress is really
moving to the community bank category. And those are
between $1 and $10 billion in assets. Those are the
great bulk of the institutions that are going
to be, you know, facing this stress. The Klaros Group analyzed
4,000 banks, screening regulatory call report
filings for banks with over 300% of capital in
commercial real estate loans and potential losses tied
to interest rates. I'm Brian Graham. I'm a founder and partner
in the Klaros Group. We thought it was important
to focus on how they measured up on those two
macroeconomic factors that are at work. 282 US banks are at risk,
with nearly $900 billion in total assets. The majority of those banks
are smaller lenders with less than $10 billion in
assets each. 16 of those banks are
larger, with anywhere from 10 to $100 billion in
assets. There's only one bank with
over $100 billion in assets. You know, one point of this
analysis is to say, look across the universe of
4,000 banks. Where are the issues going
to be? They are going to be in the
middle to small size banks, which is, by its nature,
less systemic. I think the issue is that a
lot of these smaller banks support communities away
from the coast. You're essentially
hamstringing the the economic development in
those communities. First of all, even if
they're smaller banks, the communities that rely on
them certainly care about them. The US has about 130 banks
that are considered regional banks, and collectively
they control just under $3.1 trillion in assets. The larger regional banks... They're a really important
source of credit for smaller and medium sized
businesses, local governments, nonprofits. Without regional lenders,
more businesses may have to turn to Big Banks for
services that may be more expensive and less
personable, and they may not like their options. They provide competition for
the really large, you know, mega banks, the
multi-trillion dollar banks, which is good. For individuals, the
consequences of small bank failures are more indirect. I think we have a very
stressed banking system, but the vast majority of those
banks aren't insolvent or even close to insolvent. They're just stressed. But it doesn't mean that
communities and customers don't get hurt by that
stress. The natural reaction is to
not invest in the next branch or technological
innovation, or to make the next hire. It just hurts
the community in a different way, and it hurts it more
kind of subtly and gradually and over time than a bank
failure. Directly, it's no
consequence if they're below the insured deposit limits,
which are quite high now - $250,000. That means if a bank insured
by the Federal Deposit Insurance Corporation, also
known as the FDIC, goes under, all depositors will
be paid "up to at least $250,000" per individual
per bank, per ownership category. The FDIC has really got a
strong record on this, so people should not worry. The U.S. has the largest
commercial property market globally, and banks
underwrite the majority of commercial real estate
loans. If you think about the banking industry
overall, there are four basic types of loans:. Consumer loans. CNI loans, which are
essentially loans to companies Residential
mortgage loans And, commercial real estate
loans. Regional and smaller banks
have always tended to have higher concentrations of
commercial real estate. These less that they just
made a bad decision and jumped into the commercial
real estate with both feet. And, it's more that they
just don't have the scale to compete with the larger
banks in the country in consumer lending or in
residential mortgage or in commercial and industrial
lending. And, that leaves them with a
higher concentration and exposure to commercial real
estate. The markets in general, are
poking the banks on their exposures, you know, how
are they being managed, what are some of the stresses
that they're thinking about? And most probably... Most
importantly, how are they reserving for those
potentials? When the Federal Reserve
raises rates, commercial real estate loan payments
can become more expensive for borrowers. If borrowers
can't afford payments, they may default on their loans. Federal Reserve Chairman
Jerome Powell has candidly said look, there are going
to be bank failures. It's going to happen. We have identified the banks
that have high commercial real estate concentrations,
and we are in dialogue with them around, you know, do
you have your arms around this problem? Do you have
enough capital? Are you being truthful with
yourself and with your owners? The Federal Reserve hiked
interest rates 11 times since March 2022. Interest rates being much
higher than they were a couple of years ago, means
that the value of fixed rate assets has gone down very
significantly, and that's an embedded loss going to show
up one way or another over time. And therefore, there are a
ton of unrealized losses on banks held to maturity
portfolio in terms of bonds and also the mortgages that
they issued that were all done under a low interest
rate regime. And so those are unrealized
losses. They're sitting there on
the balance sheets. This is because bonds issued
when interest rates are higher will have higher
returns for investors. If you bought a bond that's
paying 3% and interest rates are now 6%. Your 3% bond is now worth a
lot less. What that does do is it
creates pressure on what's called the net interest
margin. So, as interest rates go up, banks may need
to pay more and more interest on their deposits. But, they still have a lot
of lower yielding loans and securities. So, that really
narrow the margin. That's the way banks,
traditional banks, make money. They take deposits
and pay one rate and lend it at a higher rate. But when
rates rise, that dynamic can become inverted. When a bank sells assets
that have decreased in value, those losses become
realized. The only thing that makes
those losses unrealized is the banks haven't sold them
yet, so they're still on their books, and they're
still hoping that interest rates will go back down to
zero. And the whatever the value loss is will go away. It's classic interest rate
risk management and good banks, and good bank
executives, should know how to manage it. And I think
most are. The Fed is being cautious
about interest rate changes in 2024. However, a rate cut may not
change how much stress banks are facing. Hope is never a plan. If you're a stressed bank
in this market environment, your choices are pretty
simple. You can either hunker down
and basically shrink in order to try and match
whatever capital it is you do have. I think a lot of
institutions are likely to take that path. Regulators do allow banks to
work with their borrowers having trouble repaying
their loans. They can do a
restructuring. They can extend their maturity. They can lower the interest
rate. There may be capital
consequences for that, but nonetheless, that's usually
better than a borrower defaulting, which can be
very expensive for a bank. Or, banks can raise capital. The good news is that the
solution to this crisis can and should be a private
sector solution, not a whole bunch of government
bailouts, because the problem isn't a bunch of
insolvent banks. The problem is a bunch of
stressed and undercapitalized banks. What's the purpose of the
capital markets if not to, you know, provide capital? Take New York Community Bank
as an example. The New York Community Bank
did not fail. New York Community Bancorp
because the shares they are rising after the bank
raised more than $1 billion from a group of
investors... They pumped capital into
that institution and hopefully positioned it to
be successful and to serve its communities better than
they would have if they were still in hunker down mode. Putting $1 billion of
capital into the balance sheet. It really
strengthens the franchise and whatever issues they
are in, the loans will be able to work through. Or, stronger banks can
acquire the weaker banks. Now, the issue there that we
know is that last year was actually a 40-year low in
terms of bank M&A. It was the lowest since
1990, even before an inflation-adjusted basis. There were fewer than 100
bank acquisitions in 2023. The total value of
acquisition deals made was the lowest since 1990, at
$4.6 billion. We don't expect to see a lot
of M&A activity for the foreseeable future. I think
the merger math probably doesn't really work for
most banks right now in terms of lower equity
valuations. So, it's hard to get a
buyer and seller to agree on price right now. More importantly, what
we're also seeing is a regulatory push back on
M&A. Some regulatory institutions
are considering stricter scrutiny over merger and
acquisition deals. The Justice Department has
made public statements about this. The SEC put out a proposal
which would raise the bar for bank M&A, particularly
if you kind of cross over that the $50 billion mark. The FDIC put out a draft
statement of policy on M&A. The guidance suggested
there be really a lot of scrutiny of anything over
$100 billion. Deals of all sizes are
facing scrutiny. For example, regulators
recently refused approval of Toronto-Dominion bank's
$13.4 billion deal to acquire First Horizon
Bank. We have a problem of
concentration in the banking industry, but it's not the
regional bank level. I'm worried about
concentration at the mega bank level. I think there's some really
legitimate points that that the regulators are raising
about making sure that any mergers amongst the largest
banks in the country are subject to some pretty
strict scrutiny. Makes sense to me. I don't
think that's true for those smaller banks that are
struggling for survival. Those just don't raise the
same macroeconomic antitrust, systemic
stability. I do have a little concern
on the regulatory responses, whether they intended it
this way or not, I don't know, but are being
interpreted, and I think somewhat logically so,
being interpreted as discouraging M&A. So, I think clarifying that
M&A with a healthy bank that would result in a stable,
unified structure... I think making clear that
those are welcome and encouraged. I think that
would be good. I don't know if they're
going to do that. They seem to be going the opposite
way, but you want to be encouraging it now. That's
what I would like to see. Regulators say they are
working with bank leadership to address concerns. I think it's manageable is
the word I would use. But it's you know, it's a
very active thing for us and the other regulators. And
it will be for some time. You have regulators who are
very aware of this situation. They're now on
top of it. And they're issuing matters
requiring board attention to these institutions, and
they hope to be able to cajole them into raising
capital, to selling some assets to improve their
capital situation, and to do so in a way that doesn't
cause anything systemic. Even if a stressed bank
raises capital or hunkers down, researchers expect
some failures on the horizon. These are real economic
losses and challenges, and we'll see some, but I don't
think we'll see a massive wave of bank failures. We'll see a lot fewer bank
failures than we would otherwise. If we're
successful in attracting private capital to
recapitalize these banks, and for at least the
smaller banks, permitting some M&A and consolidation,
which would in turn attract more private capital, that
certainly would serve to reduce the number of any
bank failures we'll have. Consider the timeline of the
Great Financial Crisis and its fallout. It took about two years from
2008, so you didn't really see the peak losses and
delinquencies till about 2010. And we think the same
thing will be true this time as well, which is this is
probably going to play out over the next, probably,
two years. So, we'll probably still be
talking about this in 2025 and maybe even into 2026. There are key differences
between the bank failures of the Great Financial Crisis
and the current macroeconomic environment. The global financial crisis
was characterized by a lot of bank failures, and so we
kind of are conditioned to expect stress in the
banking system will be defined by a bunch of bank
failures. But during the Great
Financial Crisis, when it was those big banks. When
they were in trouble, we didn't have any trouble
going to the Hill and raising raising heck. At the end of the day,
that's who bank regulators need to be thinking about:
the people who use the banks. I think that kind of
shows that the policy priorities are not as
urgent when we're talking about smaller institutions,
and then this reinforces this whole "too big to
fail" idea. Most of these banks aren't
insolvent or even close to insolvent. I think we
actually have too few bank failures. The fact that our
banking system is different from that of most other
economies gives us the flexibility to allow those
banks to innovate and to experiment and to try new
things, some of which may not be successful, and we
can't do that with, you know, the biggest banks in
the country. They're just too large and
too interconnected, and the economy is too dependent on
their continued functioning. We can't
afford really, really big bank failures, but, you
know, the economy is going to be just fine if a $1
billion bank fails.
