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Banks are in limbo, without a crucial lifeline. Here’s where cracks could appear next


Banks are in limbo, without a crucial lifeline.  Here's where cracks could appear next

The forces that consumes three regional lenders in March 2023 left hundreds of smaller banks hurting, as merger activity – a key potential lifeline – slowed to a trickle.

As memories of last year’s regional banking crisis begin to fade, it’s easy to believe the sector is out of the woods. But the high interest rates that caused the collapse of the Silicon Valley Bank and its peers in 2023 are still in play.

After raising rates 11 times in July, the Federal Reserve has yet to raise rates. start cutting its reference. As a result, hundreds of billions of dollars of unrealized losses Bonds and low-interest loans remain buried on banks’ balance sheets. This, combined with potential losses on commercial real estateleaves entire sections of the industry vulnerable.

Of around 4,000 American banks analyzed by a consulting firm Klaros Group282 institutions have both high levels of exposure to commercial real estate and large unrealized losses from rising rates – a potentially toxic combination that could force these lenders to raise new capital or commit in mergers.

The study, based on regulatory filings known as call reportswas examined based on two factors: banks whose commercial real estate loans represented more than 300% of capital, and companies whose unrealized losses on bonds and loans pushed capital levels below 4%.

Klaros declined to name these institutions in its analysis for fear of inciting a run on deposits.

But this analysis only reveals one company with more than $100 billion in assets, and given the factors in the study, it’s not difficult to determine: Community Bank of New Yorkthe real estate lender that averted disaster earlier this month with a $1.1 billion investment. capital injection of private equity investors led by former Treasury Secretary Steven Mnuchin.

Most banks considered potentially in difficulty are community lenders with less than $10 billion in assets. Only 16 companies fall into the next size bracket that includes regional banks — between $10 billion and $100 billion in assets — although they collectively hold more assets than all 265 community banks combined.

Behind the scenes, regulators have encouraged banks to issue confidential orders to improve their capital levels and staffing levels, according to the Klaros co-founder. Brian Graham.

“If there were only 10 banks in trouble, they would have all been shut down and fixed,” Graham said. “When hundreds of banks face these challenges, regulators have to walk a bit of a tightrope.”

These banks must either raise capital, probably from sources of private equity as NYCB did, or merge with stronger banks, Graham said. This is what PacWest resorted to last year; the Californian lender was acquired by a smaller rival after losing deposits during the March tumult.

Banks can also choose to wait until bonds mature and are cleared from their balance sheets, but that means years of underperforming competitors, essentially operating as “zombie banks” that don’t support economic growth in their communities , Graham said. This strategy also puts them at risk of being overwhelmed by mounting loan losses.

Powell’s warning

Chairman of the Federal Reserve Jerome Powell acknowledged this month that commercial real estate losses are susceptible capsize certain small and medium-sized banks.

“This is a problem that I’m sure we’ll be working on for years to come. There will be bank failures,” Powell said. said legislators. “We’re working with them…I think it’s manageable, is the word I would use.”

There are other signs of growing tensions among smaller banks. In 2023, 67 lenders had low levels of liquidity, meaning cash or securities that can be sold quickly when needed, compared to nine institutions in 2021, Fitch analysts said in a study. recent report. They ranged in size from $90 billion in assets to less than $1 billion, according to Fitch.

And regulators have added more companies to their “List of problem banks“companies with the worst financial or operational ratings over the past year. There are 52 lenders with a total of $66.3 billion in assets on this list, up 13 from a year earlier , according to the Federal Deposit Insurance Corporation.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, United States, February 7, 2024.

Brendan McDermid | Reuters

“The bad news is that the problems facing the banking system have not magically disappeared,” Graham said. “The good news is that, compared to other banking crises I have faced, this is not a scenario in which hundreds of banks would be insolvent.”

‘Pressure cooker’

After the implosion of SVB last March, the second largest American bank failure at the time, followed by that of Signature. failure days later and that of First Republic in May, many in the industry were forecasting a wave of consolidation this could help banks cope with higher funding and compliance costs.

But agreements have been rare. Fewer than 100 bank acquisitions were announced last year, according to at the consulting firm Mercer Capital. The total deal value of $4.6 billion is the lowest since 1990, according to the report.

A big problem: Bank executives aren’t sure their transactions will meet regulatory requirements. Approval times have lengthened, particularly for large banks, and regulators have kill recent transactions, such as the $13.4 billion acquisition of First Horizon by Toronto-Dominion Bank.

A planned merger between Capital One and Discoveryannounced in February, was quickly met with calls from some lawmakers to block the transaction.

“The banks are in this pressure cooker,” said Chris Caulfield, senior partner at consulting firm West Monroe. “Regulators are playing a bigger role in possible mergers and acquisitions, but at the same time they are making it much more difficult for banks, especially smaller ones, to make a profit.”

Despite the slow pace of deals, executives at banks of all sizes recognize the need to consider mergers, according to an investment banker at one of the world’s three largest consultancies.

The level of discussion with bank CEOs is now the highest in his 23-year career, said the banker, who requested anonymity to speak about his clients.

“Everyone is talking about it and everyone recognizes that consolidation is necessary,” said the banker. “The industry has changed structurally from a profitability perspective, due to regulation and the fact that deposits will never cost zero again.”

Aging CEOs

One of the deterrents to mergers is that writedowns on bonds and loans have been too great, which would erode the capital of the merged entity as losses on some portfolios must be realized as part of a transaction. This situation has eased since the end of last year, with bond yields dived from highs of 16 years.

This, combined 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 pave the way for a new group of executives in key regulatory roles.

Easing the way for a wave of U.S. bank mergers would strengthen the system and create competition for megabanks, says Mike Mayoveteran banking analyst and former Fed employee.

“This should be a play for bank mergers, especially when the stronger ones buy the weaker ones,” Mayo said. “Restrictions on industry mergers have been the equivalent of Jamie Dimon Protection Act.”

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