Where cracks could appear in the banking sector without new mergers and acquisitions

The forces that swallowed up three regional lenders in March 2023 have left hundreds of smaller banks wounded as merger activity – a key potential lifeline – has slowed to a trickle.

As memories of last year’s regional banking crisis begin to fade, it’s easy to believe that all is well in the industry. But the high interest rates that led to the collapse of the Silicon Valley bank and its peers in 2023 are still in effect.

After raising rates 11 times in July, the Federal Reserve has yet to begin lowering its benchmark rate. As a result, hundreds of billions of dollars unrealized losses bonds and low-interest loans remain buried on banks’ balance sheets. This, coupled with potential losses on commercial real estate, leaves some parts of the industry vulnerable.

About 4,000 US banks analyzed by consulting firm Claros GroupThe 282 institutions have both high levels of exposure to commercial real estate and large unrealized losses from jumping rates—a potentially toxic combination that could force these lenders to raise new capital or engage in mergers.

Research based on normative documents known as call reportstested on two factors: banks whose commercial real estate loans accounted for more than 300% of capital, and firms whose unrealized bond and loan losses caused capital levels to fall below 4%.

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

But this analysis only found one company with more than $100 billion in assets, and given the factors in the study, it’s not hard to determine: New York Community Bankreal estate lender that avoided disaster earlier this month with $1.1 billion. capital injection from private investors led by former Treasury Secretary Steven Mnuchin.

Most banks that are considered potentially problematic public creditors with assets of less than $10 billion. Just 16 companies are in the next size group, which includes regional banks ($10 billion to $100 billion in assets), although they collectively hold more assets than the 265 community banks combined.

Behind the scenes, regulators were pushing banks with confidential orders to improve capital levels and staffing levels, the Klaros co-founder said. Brian Graham.

“If there were only 10 banks in trouble, they would all be shut down and sorted out,” Graham said. “When hundreds of banks face these problems, regulators have to walk a tightrope.”

Those banks need to either raise capital, likely from private equity sources, as NYCB has done, or merge with stronger banks, Graham said. That’s exactly what PacWest did last year; The Californian lender was acquired by a smaller rival after it lost deposits in the March riots.

Banks can also wait for the bonds to mature and disappear from their balance sheets, but that means their competitors will underperform for years, 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 being overwhelmed by mounting loan losses.

Federal Reserve Chairman Jerome Powell acknowledged this month that commercial real estate losses can knock over some small and medium sized cans.

“I’m sure this is an issue we’ll be working on for years to come. Banks will fail,” Powell. said legislators. “We’re working with them… I think it’s feasible is the word I would use.”

There are other signs of growing stress among small banks. In 2023, 67 lenders had low levels of liquidity—that is, cash or securities that could be quickly sold if needed—compared with nine institutions in 2021, Fitch analysts said in a Fitch report. Recent report. Their size ranged from $90 billion in assets to less than $1 billion, according to Fitch.

And regulators have added even more companies to their list.List of problem banksThere are 52 lenders on the list with combined assets of $66.3 billion, up 13 from a year earlier, according to the Federal Deposit Insurance Corp.

“The bad news is that the problems facing the banking system haven’t magically gone away,” Graham said. “The good news is that, compared to other banking crises I have seen, this is not a scenario where hundreds of banks become insolvent.”

After the collapse of SVB last March, the second-largest U.S. bank failure at the time, followed within days by the Signature bankruptcy and the First Republic bankruptcy in May, many in the industry predicted a wave of consolidation that could help banks cope with higher funding. and compliance costs.

But there were very few deals. Fewer than 100 bank takeovers were announced last year. according to consulting firm Mercer Capital. The total value of the deal was $4.6 billion, the lowest since 1990.

One big problem: Bank executives aren’t confident their deals will pass regulatory scrutiny. Timelines for obtaining approval have lengthened, especially for large banks, and regulators killed recent transactions such as the acquisition of First Horizon by Toronto-Dominion Bank.

The planned merger of Capital One and Discovery, announced in February, was immediately met with calls from some lawmakers block translation.

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

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

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

“Everyone is talking and there is recognition that consolidation has 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 be worth zero again.”

Another reason to expect increased merger activity is the age of bank executives. A third of regional bank executives are over 65, older than the group’s average retirement age, according to 2023 data from executive search firm Spencer Stuart. According to the company, this could lead to a wave of layoffs in the coming years.

“A lot of people are tired,” said Frank Sorrentino, an investment banker at advisory firm Stephens. “This is a complex industry and there are a lot of people wanting to do a deal, whether it be an outright sale or a merger.”

Sorrentino participated in the January merger between FirstSun and The main street, a Seattle bank whose shares fell last year due to funding cuts. He forecasts a surge in merger activity from lenders worth between $3 billion and $20 billion in assets as smaller firms look to expand.

One of the deterrents to mergers is that the write-downs on the bonds and loans were too deep, which would reduce the combined company’s equity in the deal as losses on some portfolios must be realized in the transaction. The situation has worsened since late last year as bond yields have fallen from 16-year highs.

That, along with a rebound in bank stocks, will lead to more activity this year, Sorrentino said. Other bankers said larger deals were likely to be announced after the U.S. presidential election, which could usher in a new group of leaders in key regulatory positions.

Easing the wave of bank mergers in the U.S. will strengthen the system and create competition for megabanks, according to Mike Mayo, a veteran banking analyst and former Fed official.

“This should be a push for bank mergers, especially strong ones buying weak ones,” Mayo said. “The industry’s merger restrictions were the equivalent of the Jamie Dimon Protection Act.”