Introduction
Stressed Banks pose significant risks to the U.S. economy, threatening financial stability and economic growth. Learn about the implications and potential consequences.
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, a 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 have 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.
Why Hundreds of Small Banks Are At Risk
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 U.S. 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 of small 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 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 U.S. 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, and 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.
Commercial Real Estate Loans
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 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, in residential mortgages, 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 retaining 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 has 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 portfolios 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 is create 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 narrows 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 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?
Mergers and Acquisitions
For instance, let’s discuss New York Community Bank. New York Community Bank for instance did not fail. New York Community Bancorp is a prospective choice since the share prices flared up after the bank hiked more than $1bn from a group of investors.
They invested in that institution and presumably shaped it to be successful and to serve its communities than they would if otherwise. It important for banks to consolidate as an aspect of survival since mergers and acquisitions, or M&As, make entities stronger.
However, mergers and acquisitions of banks have slowed down in the recent past as will be analyzed. There was a decrease of mergers and acquisitions of banks in 2023 by about 160 as compared to previous years.
Part of that is because of more decadent interest rates available in the world economy. Higher interest rates thus make it challenging to value the banks and make potential acquirers reluctant to unleash their acquisition offers.
Banks are no longer as attractive of an acquisition because their loan portfolios have become less secure with the ability to raise rates and commercial real estate assets. However, there was credibility in the attempt by some banks to being recapitalized through the exercises popularly known as M&As.
For instance, New York Community Bank’s flagstar bank merger was a successful recapitalization that helped the acquiring bank increase its market share, as well as sources of funds for the loans. As some of the banks that manage to look for capital or find acquirers sadly become better off and emerge stronger.
The stress to get capital in the banking sector is therefore to identify ways of getting capital without compromising the facility, risks and costs associated with the capital acquisition.
Conclusion
The pressure on hundreds of small and regional banks is an indication of other problems facing the banking industry.
The situation is that these banks have high risk since they have lot commercial real estate exposure and the effect of increasing rates. However, that is where regulation comes in and potential breakthroughs in the private sector can reduce the impact of these challenges.
To move across the increasingly complex terrain of contemporary banking and design positive changes for the evolution of a more robust financial environment, it is essential to describe the current conditions and brainstorm the possible solutions.