The Crucial Lifeline Banks Rely on is Missing: Identifying Potential Areas of Vulnerability
In the aftermath of the regional banking crisis in March 2023, smaller banks are facing potential vulnerability as merger activity has slowed down significantly. While it may seem that the banking industry is out of the woods, the high interest rates that caused the collapse of Silicon Valley Bank and its peers are still a concern. The Federal Reserve has yet to start cutting its benchmark interest rates, leaving hundreds of billions of dollars of unrealized losses on banks’ balance sheets. The combination of these losses and potential losses on commercial real estate puts a large portion of the industry at risk.
A recent study conducted by consulting firm Klaros Group analyzed 4,000 U.S. banks and identified 282 institutions with high levels of commercial real estate exposure and large unrealized losses. These banks may be forced to raise fresh capital or engage in mergers in order to survive. The study did not disclose the names of these institutions to prevent causing deposit runs. However, it is clear that New York Community Bank, with over $100 billion in assets, is one of the banks identified as potentially vulnerable.
Most of the banks facing challenges are community lenders with less than $10 billion in assets. Only 16 companies fall into the next size bracket, which includes regional banks with assets between $10 billion and $100 billion. Despite being fewer in number, these 16 companies collectively hold more assets than the 265 community banks combined.
Regulators have been pressuring banks to improve their capital levels and staffing behind the scenes. Confidential orders have been issued to banks to address these issues. Brian Graham, co-founder of Klaros Group, believes that these banks need to raise capital or merge with stronger banks in order to survive. Waiting for bonds to mature and roll off their balance sheets is an option, but it would mean years of underperformance compared to their rivals and the risk of rising loan losses.
Federal Reserve Chair Jerome Powell has acknowledged that commercial real estate losses may lead to bank failures among small and medium-sized banks. However, he believes that the situation is manageable. Other signs of stress among smaller banks include low levels of liquidity and an increase in the number of companies on the “Problem Bank List” of institutions with poor financial or operational ratings.
Despite predictions of a wave of consolidation in the banking industry, deals have been few and far between. Bank executives are uncertain about whether their deals will pass regulatory scrutiny. Approval timelines have lengthened, especially for larger banks, and regulators have rejected recent deals. The pressure on banks from regulators is making it harder for them to turn a profit.
However, there is a growing recognition among bank leaders that mergers are necessary. CEOs of regional banks are getting older, with a third of them being older than 65. This could lead to a wave of departures in the coming years, creating opportunities for mergers and acquisitions. Bond and loan markdowns have been a deterrent to mergers, but they have eased in recent months. The recovering bank stocks and potential new regulatory leaders after the U.S. presidential election may also contribute to increased merger activity.
Veteran bank analyst Mike Mayo believes that easing restrictions on bank mergers would strengthen the system and create challengers to the megabanks. He sees it as an opportunity for the strong to acquire the weak.
In conclusion, while it may seem like the banking industry has recovered from the regional banking crisis, there are still potential areas of vulnerability. Banks with high levels of commercial real estate exposure and large unrealized losses are at risk and may need to raise capital or engage in mergers to survive. Regulators have been pressuring banks to improve their capital levels and staffing, but the path to mergers has been challenging due to regulatory uncertainty. However, a wave of departures among aging bank CEOs and easing bond and loan markdowns may lead to increased merger activity in the near future.
