The forces that consumed three regional lenders in March 2023 have left tons of of smaller banks wounded, as merger activity — a key potential lifeline — has slowed to a trickle.
As the memory of last yr’s regional banking crisis begins to fade, it is easy to consider the industry is in the clear. But the high rates of interest that caused the collapse of Silicon Valley Bank and its peers in 2023 are still at play.
After mountain climbing rates 11 times through July, the Federal Reserve has yet to begin cutting its benchmark. Because of this, tons of of billions of dollars of unrealized losses on low-interest bonds and loans remain buried on banks’ balance sheets. That, combined with potential losses on industrial real estate, leaves swaths of the industry vulnerable.
Of about 4,000 U.S. banks analyzed by consulting firm Klaros Group, 282 institutions have each high levels of business real estate exposure and enormous unrealized losses from the rate surge — a potentially toxic combo that may force these lenders to lift fresh capital or engage in mergers.
The study, based on regulatory filings often known as call reports, screened for 2 aspects: Banks where industrial real estate loans made up over 300% of capital, and firms where unrealized losses on bonds and loans pushed capital levels below 4%.
Klaros declined to call the institutions in its evaluation out of fear of inciting deposit runs.
But there’s just one company with more than $100 billion in assets found in this evaluation, and, given the aspects of the study, it isn’t hard to find out: Recent York Community Bank, the real estate lender that avoided disaster earlier this month with a $1.1 billion capital injection from private equity investors led by ex-Treasury Secretary Steven Mnuchin.
Most of the banks deemed to be potentially challenged are community lenders with lower than $10 billion in assets. Just 16 corporations are in the next size bracket that features regional banks — between $10 billion and $100 billion in assets — though they collectively hold more assets than the 265 community banks combined.
Behind the scenes, regulators have been prodding banks with confidential orders to enhance capital levels and staffing, in accordance with Klaros co-founder Brian Graham.
“If there have been just 10 banks that were in trouble, they might have all been taken down and handled,” Graham said. “Whenever you’ve got tons of of banks facing these challenges, the regulators should walk a little bit of a tightrope.”
These banks must either raise capital, likely from private equity sources as NYCB did, or merge with stronger banks, Graham said. That is what PacWest resorted to last yr; the California lender was acquired by a smaller rival after it lost deposits in the March tumult.
Banks can even decide to wait as bonds mature and roll off their balance sheets, but doing so means years of underearning rivals, essentially operating as “zombie banks” that do not support economic growth in their communities, Graham said. That strategy also puts them liable to being swamped by rising loan losses.
Powell’s warning
Federal Reserve Chair Jerome Powell acknowledged this month that industrial real estate losses are likely to capsize some small and medium-sized banks.
“It is a problem we’ll be working on for years more, I’m sure. There will probably be bank failures,” Powell told lawmakers. “We’re working with them … I feel it’s manageable, is the word I’d use.”
There are other signs of mounting stress amongst smaller banks. In 2023, 67 lenders had low levels of liquidity — meaning the money or securities that could be quickly sold when needed — up from nine institutions in 2021, Fitch analysts said in a recent report. They ranged in size from $90 billion in assets to under $1 billion, in accordance with Fitch.
And regulators have added more corporations to their “Problem Bank List” of corporations with the worst financial or operational rankings in the past yr. There are 52 lenders with a combined $66.3 billion in assets on that list, 13 more than a yr earlier, in accordance with the Federal Deposit Insurance Corporation.
Traders work on the floor at the Recent York Stock Exchange (NYSE) in Recent York City, U.S., February 7, 2024.
Brendan Mcdermid | Reuters
“The bad news is, the problems faced by the banking system have not magically gone away,” Graham said. “The excellent news is that, in comparison with other banking crises I’ve worked through, this is not a scenario where tons of of banks are insolvent.”
‘Pressure cooker’
After the implosion of SVB last March, the second-largest U.S. bank failure at the time, followed by Signature’s failure days later and that of First Republic in May, many in the industry predicted a wave of consolidation that might help banks take care of higher funding and compliance costs.
But deals have been few and much between. There have been fewer than 100 bank acquisitions announced last yr, according to advisory firm Mercer Capital. The whole deal value of $4.6 billion was the lowest since 1990, it found.
One big hang-up: Bank executives are uncertain that their deals will pass regulatory muster. Timelines for approval have lengthened, especially for larger banks, and regulators have killed recent deals, comparable to the $13.4 billion acquisition of First Horizon by Toronto-Dominion Bank.
A planned merger between Capital One and Discovery, announced in February, was promptly met with calls from some lawmakers to block the transaction.
“Banks are in this pressure cooker,” said Chris Caulfield, senior partner at consulting firm West Monroe. “Regulators are playing an even bigger role in what M&A can occur, but at the same time, they’re making it much harder for banks, especially smaller ones, to give you the chance to show a profit.”
Despite the slow environment for deals, leaders of banks all along the size spectrum recognize the need to think about mergers, in accordance with an investment banker at a top-three global advisory firm.
Discussion levels with bank CEOs at the moment are the highest in his 23-year profession, said the banker, who requested anonymity to discuss clients.
“Everyone’s talking, and there is acknowledgment consolidation has to occur,” said the banker. “The industry has structurally modified from a profitability standpoint, due to regulation and with deposits now being something that will not ever cost zero again.”
Aging CEOs
One more reason to expect heightened merger activity is the age of bank leaders. A 3rd of regional bank CEOs are older than 65, beyond the group’s average retirement age, in accordance with 2023 data from executive search firm Spencer Stuart. That could lead on to a wave of exits in coming years, the firm said.
“You have quite a lot of folks who’re drained,” said Frank Sorrentino, an investment banker at boutique advisory Stephens. “It has been a tricky industry, and there are quite a lot of willing sellers who need to transact, whether that is an outright sale or a merger.”
Sorrentino was involved in the January merger between FirstSun and HomeStreet, a Seattle-based bank whose shares plunged last yr after a funding squeeze. He predicts a surge in merger activity from lenders between $3 billion and $20 billion in assets as smaller firms look to scale up.
One deterrent to mergers is that bond and loan markdowns have been too deep, which might erode capital for the combined entity in a deal because losses on some portfolios should be realized in a transaction. That has eased since late last yr as bond yields dipped from 16-year highs.
That, together with recovering bank stocks, will result in more activity this yr, Sorrentino said. Other bankers said that larger deals are more prone to be announced after the U.S. presidential election, which could usher in a latest set of leaders in key regulatory roles.
Easing the path for a wave of U.S. bank mergers would strengthen the system and create challengers to the megabanks, in accordance with Mike Mayo, the veteran bank analyst and former Fed worker.
“It must be game-on for bank mergers, especially the strong buying the weak,” Mayo said. “The merger restrictions on the industry have been the equivalent of the Jamie Dimon Protection Act.”