Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, USA, February 7, 2024.
Brendan Mcdermid | Reuters
The forces that engulfed three regional lenders in March 2023 have ravaged hundreds of smaller banks as merger activity – a key potential lifeline – has fallen to a minimum.
As memories of last year’s regional banking crisis begin to fade, it’s easy to believe that the industry is in the clear. But the high interest rates that caused the collapse of Silicon Valley Bank and its competitors in 2023 are still in play.
After raising interest rates 11 times through July, the Federal Reserve has yet to begin cutting its key interest rate. As a result, hundreds of billions of dollars in unrealized losses from low-interest bonds and loans remain on banks’ balance sheets. Combined with potential losses in commercial real estate, this leaves parts of the industry vulnerable.
Of the approximately 4,000 U.S. banks analyzed by consulting firm Klaros Group, 282 institutions have both high exposure to commercial real estate and large unrealized losses from the rise in interest rates – a potentially toxic combination that could force these lenders to seek fresh capital to take part or participate in mergers.
The study, based on regulatory filings called call reports, looked at two factors: banks where commercial real estate loans accounted for over 300% of capital and companies where unrealized losses on bonds and loans pushed capital levels below 4%.
Klaros declined to name the institutions in his analysis for fear of a deposit storm.
However, only one company with more than $100 billion in assets was found in this analysis, and given the study’s factors, it is not difficult to determine: New York Community Bankthe real estate lender that averted disaster earlier this month with a $1.1 billion capital injection from private equity investors led by former Treasury Secretary Steven Mnuchin.
Most of the banks considered potentially challenged are municipal lenders with less than $10 billion in assets. Only 16 companies are in the next largest size class that includes regional banks—between $10 billion and $100 billion in assets—even though they collectively hold more assets than the 265 community banks combined.
According to Klaros co-founder Brian Graham, regulators have been giving banks confidential instructions behind the scenes to improve capital and staffing levels.
“If there were just 10 banks that were in trouble, they would all have been torn down and dealt with,” Graham said. “When hundreds of banks face these challenges, regulators have to walk a certain balancing act.”
These banks will either need to raise capital, likely from private equity sources, as NYCB has done, or merge with stronger banks, Graham said. PacWest resorted to this last year; The California lender was acquired by a smaller rival after it lost deposits during the March turmoil.
Banks could also choose to wait for the bonds to mature and then exit their balance sheets. But that means they will underpay their competitors for years and essentially operate as “zombie banks” that don’t support economic growth in their communities, Graham said. This strategy also carries the risk of being swamped by mounting credit losses.
Powell’s warning
Federal Reserve Chairman Jerome Powell acknowledged this month that losses in commercial real estate are likely to capsize some small and medium-sized banks.
“This is a problem that we will be working on for many years to come, I am sure. There will be bank failures,” Powell told lawmakers. “We’re working with them… I think it’s manageable, that’s the word I would use.”
There are other signs of increasing stress at smaller banks. In 2023, 67 lenders had low liquidity – meaning cash or securities that can be sold quickly if needed – compared to nine institutions in 2021, Fitch analysts said in a recent report. According to Fitch, their wealth ranged from $90 billion to less than $1 billion.
And regulators last year added more companies to their “problem bank list” of companies with the worst financial or operational ratings. According to the Federal Deposit Insurance Corporation, there are 52 lenders on that list with total assets of $66.3 billion, up 13 from a year earlier.
“The bad news is that the banking system’s problems haven’t magically disappeared,” Graham said. “The good news is that compared to other banking crises I have experienced, this is not a scenario where hundreds of banks are insolvent.”
‘pressure cooker’
After SVB’s implosion last March, the second-largest bank failure in the U.S. at the time, followed by Signature’s failure days later and First Republic’s in May, many in the industry predicted a wave of consolidation that could help banks cope higher financing and compliance costs.
But there were few deals. According to consulting firm Mercer Capital, fewer than 100 bank takeovers were announced last year. The total value of the deal was $4.6 billion, the lowest since 1990, it said.
A big problem is that bank executives are unsure whether their businesses will pass regulatory scrutiny. Approval timelines have lengthened, particularly for larger banks, and regulators have thwarted recent deals such as the $13.4 billion takeover of First Horizon Toronto Dominion Bank.
A proposed merger between Capital One and Discovery announced in February was immediately met with calls from some lawmakers to block the deal.
“Banks are in this pressure cooker,” said Chris Caulfield, senior partner at consulting firm West Monroe. “Regulators are playing a larger role in mergers and acquisitions, but at the same time are making it much harder for banks, especially smaller ones, to turn a profit.”
Banking leaders of all sizes are recognizing the need to consider mergers despite the slow deal environment, according to an investment banker at one of the world’s top three consulting firms.
The level of conversation with bank CEOs is now the highest in his 23-year career, said the banker, who asked to remain anonymous to discuss clients.
“Everyone is talking and there is an understanding that consolidation needs to happen,” the banker said. “The industry has changed structurally in terms of profitability due to regulation and the fact that deposits will now never cost zero again.”
Aging CEOs
Another reason to expect increased merger activity is the age of bank leaders. According to 2023 data from executive search firm Spencer Stuart, a third of regional bank CEOs are over 65, above the group’s average retirement age. That could lead to a wave of departures in the coming years, the company said.
“There are a lot of people who are tired,” said Frank Sorrentino, an investment banker at boutique advisory firm Stephens. “It’s been a difficult industry and there are a lot of willing sellers looking to do a deal, whether it’s an outright sale or a merger.”
Sorrentino was involved in the January merger between FirstSun and Home Street, a Seattle-based bank whose shares plunged last year due to a funding crunch. He predicts an increase in merger activity among lenders with $3 billion to $20 billion in assets as smaller companies look to expand.
One deterrent to mergers is that discounts on bonds and loans are too high, which would result in a capital loss to the combined company in a transaction, as losses on some portfolios must be realized in a transaction. Since the end of last year, that trend has moderated as bond yields fell from their 16-year peak.
That, along with the recovery in bank stocks, will lead to more activity this year, Sorrentino said. Other bankers said larger deals were more likely to be announced after the U.S. presidential election, which could result in a new group of executives taking on key regulatory roles.
Paving the way for a wave of U.S. bank mergers would strengthen the system and create challengers to the megabanks, said Mike Mayo, the veteran banking analyst and former Fed official.
“When it comes to bank mergers, it should be important that the strong buy the weak,” said Mayo. “The industry merger restrictions were the equivalent of the Jamie Dimon Protection Act.”
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2024-03-19 10:15:01
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