The forces that consumed three regional banks in March 2023 have left hundreds of smaller banks battered, with merger activity – a potential major lifeline – slowing to a trickle.
As the memory of last year's regional banking crisis begins to fade, it's easy to think the industry is in the clear. But the high interest rates that caused the Silicon Valley bank and its peers to collapse in 2023 are still having an impact.
After raising interest rates 11 times during July, the Federal Reserve has yet to start cutting interest rates. As a result, hundreds of billions of dollars in unrealized losses on bonds and low-interest loans remain buried on banks' balance sheets. This, combined with potential losses in commercial real estate, leaves large sectors of the industry vulnerable.
Of about 4,000 U.S. banks analyzed by consulting firm Clarus Group, 282 institutions have high levels of exposure to commercial real estate and large unrealized losses from rising interest rates — a potentially toxic combination that could force these lenders to raise new capital or engage in… Mergers.
The study, based on regulatory filings known as call reports, examined two factors: banks where commercial real estate loans make up more than 300% of capital, and companies where unrealized losses on bonds and loans pushed capital levels below 4%.
Claros declined to name the institutions in its analysis for fear of inciting deposit withdrawals.
But there's only one company with assets worth more than $100 billion in this analysis, and given the study's factors, it's not hard to spot: Community Bank of New Yorkthe mortgage lender that averted disaster earlier this month with a $1.1 billion capital infusion from private equity investors led by former Treasury Secretary Steven Mnuchin.
Most of the banks likely to face challenges are community lenders with less than $10 billion in assets. There are just 16 companies in the next size bracket that includes regional banks — their assets range between $10 billion and $100 billion — even though they collectively have more assets than the 265 community banks combined.
Behind the scenes, regulators have been urging banks with secret orders to improve capital and staffing levels, according to Clarus co-founder Brian Graham.
“If there were just 10 problem banks, they could all be removed and dealt with,” Graham said. “When you have hundreds of banks facing these challenges, regulators have to walk a bit of a tightrope.”
These banks need to either raise capital, likely from private equity sources as the New York central bank did, or merge with stronger banks, Graham said. This is what PacWest resorted to last year; The Bank of California was taken over by a smaller rival after losing deposits in the March unrest.
Banks could also choose to wait until bonds mature and divest their balance sheets, but doing so would mean years of weakened competitors, essentially acting as “zombie banks” that don't support economic growth in their communities, Graham said. This strategy also exposes them to the risk of drowning due to high loan losses.
Powell's warning
Federal Reserve Chairman Jerome Powell acknowledged this month that commercial real estate losses would likely turn on some small and medium-sized banks.
“This is a problem that we're going to be working on for years to come,” Powell told lawmakers. “I'm sure there will be bank failures.” “We're working with them…I think it's manageable, that's the word I would use.”
There are other signs of mounting pressure among smaller banks. In 2023, 67 banks had low levels of liquidity — that is, cash or securities that can be sold quickly when needed — up from nine institutions in 2021, Fitch analysts said in a recent report. Their size ranged from $90 billion in assets to less than $1 billion, according to Fitch.
Regulators have added more companies to their “distressed banks list” of companies with the worst financial or operating ratings in the past year. There are 52 lenders with combined assets of $66.3 billion on that list, 13 more than the previous year, according to the Federal Deposit Insurance Corporation.
Traders work on the floor at the New York Stock Exchange in New York City, US, February 7, 2024.
Brendan McDiarmid | Reuters
“The bad news is that the problems facing the banking system have not magically gone away,” Graham said. “The good news is that, compared to other banking crises I have worked through, this is not a scenario in which hundreds of banks are insolvent.”
'pressure cooker'
After the collapse of SVB last March, the second-largest U.S. bank failure at the time, which was followed by Signature's failure days later and First Republic's failure in May, many in the industry expected a wave of consolidation that could help banks deal with higher funding and compliance costs.
But the deals were few and far between. Fewer than 100 bank takeovers were announced last year, according to advisory firm Mercer Capital. It found that the total deal value of $4.6 billion was the lowest since 1990.
One big hurdle: Bank executives aren't sure their deals will pass regulatory requirements. Approval timelines have lengthened, especially for big banks, and regulators have canceled recent deals, such as the $13.4 billion acquisition by First Horizon. Toronto Dominion Bank.
The planned merger between Capital One and Discovery, announced in February, was immediately met with calls from some lawmakers to block the deal.
“The banks are in this pressure cooker,” said Chris Caulfield, senior partner at West Monroe Consulting. “Regulators are playing a bigger role in what mergers and acquisitions can happen, but at the same time, they are making it very difficult for banks, especially smaller ones, to be able to turn a profit.”
Despite the sluggish deal environment, bank leaders from across the spectrum are recognizing the need to consider mergers, according to an investment banker at the three largest global advisory firms.
The banker, who requested anonymity to talk about clients, said levels of discussion with bank CEOs were now the highest in his 23-year career.
“Everyone is talking, and there is recognition that the merger needs to happen,” the banker said. “The industry has changed structurally from a profitability standpoint, due to regulation and with deposits now being something that will never cost zero again.”
Aging CEOs
Another reason to expect increased merger activity is the age of bank leaders. A third of regional bank CEOs are over 65, well above the group's average retirement age, according to 2023 data from executive search firm Spencer Stewart. The company said this could lead to a wave of departures in the coming years.
“There are a lot of people who are feeling tired,” said Frank Sorrentino, an investment banker at Stevens Advisory. “It's been a tough industry, and there are a lot of sellers wanting to do business, whether it's a direct sale or a merger.”
Sorrentino was involved in the January merger between FirstSun and… Home Street, a Seattle-based bank whose shares fell last year after financing pressures. He expects an increase in merger activity from lenders with between $3 billion and $20 billion in assets as small businesses look to expand.
One impediment to mergers is that bond and loan price reductions have been too deep, which would erode capital for the combined entity in the deal because losses on some portfolios would have to be realized in the deal. That has been declining since late last year as bond yields fell from 16-year highs.
That, coupled with a recovery in bank stocks, will lead to more activity this year, Sorrentino said. Other bankers said larger deals were likely to be announced after the US presidential election, which could herald a new crop of leaders in key regulatory roles.
Smoothing the path for a wave of U.S. bank mergers would strengthen the system and create competitors for the giant banks, according to Mike Mayo, a veteran banking analyst and former Federal Reserve staffer.
“This should be the game for bank mergers, especially strong banks buying weak ones,” Mayo said. “The merger restrictions imposed on the industry were the equivalent of the Jimmy Dimon Protection Act.”
