Why Hundreds Of U.S. Banks Are At Risk Of Failing

Hundreds of small and regional

banks

across the United States are feeling stressed. More than 280

banks

face the double threat of commercial real estate loans and potential losses tied to higher interest rates. I have no doubt that there will be more bank failures or at least they will fall below their minimum capital requirements. There will be bank failures. But these are not the big banks. Rapid increases in interest rates can mean that borrowers suddenly face more expensive loan payments and, if they cannot afford to pay, they may default on their loans. A record $929 billion in loans are coming due — that is, due in 2024 — driven by “massive extensions” of loans that were originally due in 2023.

Regulators are working behind the scenes with potentially at-

risk

lenders. They are issuing confidential reports that go unnoticed, saying that you have to raise your capital. We will see far fewer bank failures than we would if we were able to attract private capital to recapitalize these banks. These are banks that probably need to raise capital, or could try to be acquired by a stronger bank. However, banking sector acquisitions have slowed. These stressed banks could have big implications for the US economy. It's been a year since the collapse of Silicon Valley Bank... Of course, we're seeing cracks forming again a year later.

Both the major and regional bank indices continue to struggle since the bank failures of 2023. I think most of them are fine. But trust is everything in banking. If people start to lose trust, even healthy banks can be negatively affected. Here's why

hundreds

of small banks may be at

risk

of bankruptcy and how insolvency can be avoided. The United States has thousands of banks. There are about 4,600 banks in the United States. But in most of the world's developed economies there are no regional and community banks. Approximately 4,000 banks in the US are small banks, also known as community banks.

Adding up the collective assets of those 4,000 banks, the smaller banks control roughly the same value of assets as America's largest bank, J.P. Bank. Morgan Chase, with $3.2 trillion in assets. Now, the tension is really shifting to the community bank category. And that's between $1 billion and $10 billion in assets. Those are the vast majority of institutions that, you know, will face this tension. The Klaros Group analyzed 4,000 banks, examining the regulatory reporting filings of banks with more than 300% equity in commercial real estate loans and potential losses linked to interest rates. I'm Brian Graham. I am founder and partner of the Klaros Group.

We thought it was important to focus on how they measured those two macroeconomic factors at play. 282 US banks are at risk, with nearly $900 billion in total assets. Most of those banks are smaller lenders with less than $10 billion in assets each. 16 of those banks are larger and have between $10 billion and $100 billion in assets. There is only one bank with more than $100 billion in assets. You know, one point of this analysis is to look across the universe of 4,000 banks. Where will the problems be? They will be medium to small sized banks, which is, by nature, less systemic. I think the problem is that many of these smaller banks support communities far from the coast.

You're basically crippling the economic development of those communities. First of all, even if they are smaller banks, the communities that depend on them certainly care about them. The United States has about 130 banks that are considered regional banks and together they control just under $3.1 trillion in assets. The largest regional banks... They are a really important source of credit for small and medium-sized businesses, local governments and nonprofit organizations. Without regional lenders, more businesses may have to turn to big banks for services that may be more expensive and less palatable, and they may not like their options. They offer competition to the really big megabanks, the multi-billion dollar banks, which is good.

For individuals, the consequences of small bank failures are more indirect. I think we have a very stressed banking system, but the vast majority of those banks are not insolvent or even close to being insolvent. They are just stressed. But that doesn't mean communities and customers aren't affected by that stress. The natural reaction is not to invest in the next branch or technological innovation, or make the next hire. It just hurts the community in a different way, and it hurts it more subtly, gradually, and over time than a bank failure. Directly, there are no consequences if they are below the insured deposit limits, which are now quite high: $250,000.

That means that if a bank insured by the Federal Deposit Insurance Corporation, also known as the FDIC, fails, all depositors will receive "up to at least $250,000" per individual per bank, per ownership category. The FDIC really has a solid track record in this regard, so people shouldn't worry. The United States has the largest commercial real estate market in the world and banks underwrite the majority of commercial real estate loans. If you think about the banking industry in general, there are four basic types of loans: Consumer loans. CNI loans, which are essentially loans to businesses. Residential mortgage loans and commercial real estate loans.

Regional and smaller banks have always tended to have higher concentrations of commercial real estate. These less than simply made a bad decision and jumped into commercial real estate with both feet. And what's more, they simply don't have the scale to compete with the nation's largest banks in consumer lending or residential mortgages or commercial and industrial lending. And that leaves them with greater concentration and exposure to commercial real estate. Markets in general are putting pressure on banks on their exposures, you know, how are they being managed? What are some of the tensions you're thinking about? And most likely...

Most importantly, how are you booking for those potentials? When the Federal Reserve raises rates, commercial real estate loan payments can become more expensive for borrowers. If borrowers cannot make payments, they may default on their loans. Federal Reserve Chairman Jerome Powell has said frankly: "There are going to be bank failures." It will happen. We have identified the banks that have high concentrations of commercial real estate and we are in dialogue with them about, you know, do you have this problem under control? Do you have enough capital? Are you being honest with yourself and your owners? The Federal Reserve has raised interest rates 11 times since March 2022.

The fact that interest rates are much higher than they were a couple of years ago means that the value of fixed rate assets has dropped very significantly, and that is an implicit loss that will show up one way or another over time. And therefore, there are a lot of unrealized losses in the banks' held-to-maturity portfolios in terms of bonds and also the mortgages that they issued, all of them under a low interest rate regime. And so those are unrealized losses. They are there in the balance sheets. This is because bonds issued when interest rates are higher will have higher returns for investors.

If you bought a bond, you will pay 3% and interest rates are now 6%. Your 3% bonus is now worth much less. What that does is create pressure on what's called the net interest margin. Therefore, as interest rates rise, banks may have to pay more and more interest on their deposits. But they still have many lower-yielding loans and securities. So that really reduces the margin. That's how banks, traditional banks, make money. They take deposits, pay a rate, and lend at a higher rate. But when rates rise, that dynamic can reverse. When a bank sells assets that have declined in value, those losses become a reality.

The only thing keeping those losses from being realized is that the banks haven't sold them yet, so they're still on their books, and they're still waiting for interest rates to go back down to zero. And whatever the loss in value is will disappear. It is classic interest rate risk management and good banks and good bank executives should know how to manage it. And I think most of them are. The Federal Reserve is being cautious about interest rate changes in 2024. However, a rate cut may not change the level of stress banks face. Hope is never a plan.

If you are a stressed bank in this market environment, your options are pretty simple. You can crouch and basically shrink to try to match whatever capital you have. I think it's likely that many institutions will follow that path. Regulators allow banks to work with their borrowers who are having trouble repaying their loans. They can do a restructuring. They can extend their maturity. They can lower the interest rate. There may be capital consequences for that, but even so, that's usually better than a borrower defaulting, which can be very costly for a bank. Or banks can raise capital.

The good news is that the solution to this crisis can and should be a private sector solution, not a bunch of government bailouts, because the problem is not a bunch of insolvent banks. The problem is a group of stressed and undercapitalized banks. What is the purpose of capital markets if not, you know, providing capital? Take New York Community Bank, for example. The New York Community Bank did not fail. New York Community Bancorp because the stock is rising after the bank raised more than $1 billion from a group of investors... They injected capital into that institution and hopefully positioned it to succeed and serve their communities better than they would have if they were still in crouch mode.

Putting $1 billion of capital on the balance sheet. It really strengthens the franchise and whatever problem they have, the loans can be resolved. Or stronger banks can acquire weaker banks. Now, the problem we know is that last year was actually a 40-year low in terms of bank mergers and acquisitions. It was the lowest since 1990, even before an inflation-adjusted basis. In 2023 there were fewer than 100 bank acquisitions. The total value of acquisition deals made was the lowest since 1990, at $4.6 billion. We don't expect to see much M&A activity in the foreseeable future. I think the merger math probably doesn't work for most banks right now in terms of lower capital valuations.

Therefore, it is difficult to get a buyer and seller to agree on price at this time. More importantly, what we are also seeing is regulatory pushback on mergers and acquisitions. Some regulators are considering tougher scrutiny of M&A deals. The Department of Justice has made public statements on the matter. The SEC put forward a proposal that would raise the bar for bank mergers and acquisitions, especially if they break the $50 billion mark. The FDIC released a draft policy statement on mergers and acquisitions. The guidance suggested that there would really be a lot of scrutiny on anything over $100 billion.

Businesses of all sizes face scrutiny. For example, regulators recently rejected approval of Toronto-Dominion Bank's $13.4 billion deal to acquire First Horizon Bank. We have a concentration problem in the banking industry, but it is not at the regional banking level. I am concerned about the concentration at the megabank level. I think there are some really legitimate points that regulators are raising to make sure that any merger between the largest banks in the country is subject to fairly strict scrutiny. It makes sense to me. I don't think that's true for smaller banks struggling to survive. Those just don't generate the same macroeconomic antitrust and systemic stability.

I'm a little concerned about the regulatory responses, whether they intended it this way or not, I don't know, but they are being interpreted, and I think somewhat logically, as discouraging M&A. So I think making it clear that M&A with a healthy bank would result in a stable, unified structure... I think making it clear that they are welcomed and encouraged. I think that would be good. I don't know if they're going to do that. They seem to be going in the right directioncontrary, but you want to encourage him now. That's what I'd like to see.

Regulators say they are working with banking leaders to address concerns. I think manageable is the word I would use. But you know, it's a very active thing for us and the other regulators. And it will be for some time. There are regulators who are very aware of this situation. Now they're on top of it. And they are raising issues that require the attention of the board of directors of these institutions, and they hope that they can cajole them into raising capital and selling some assets to improve their capital situation, and do it in a way that doesn't cause anything systemic. .

Even if a struggling bank raises capital or takes refuge, researchers expect some bankruptcies on the horizon. These are real economic losses and challenges, and we will see some, but I don't think we will see a massive wave of bank failures. We will see far fewer bank failures than we would otherwise. If we can attract private capital to recapitalize these banks, and at least for the smaller banks, allowing for some mergers and acquisitions and consolidations, which in turn would attract more private capital, that would certainly serve to reduce the number of bank failures that 'i I will have.

Let's consider the chronology of the Great Financial Crisis and its consequences. It's been about two years since 2008, so you didn't really see the peak losses and defaults until about 2010. And we think the same thing will be true this time as well, which is that this will probably play out over the next few years. Probably two years. Therefore, we will probably still be talking about this in 2025 and perhaps even 2026. There are key differences between the bank failures of the Great Financial Crisis and the current macroeconomic environment. The global financial crisis was characterized by many bank failures, so we are conditioned to expect that stress in the banking system will be defined by a series of bank failures.

But during the Great Financial Crisis, when those big banks were. When they were in trouble, we had no problem going to the Hill and doing all kinds of things. After all, that's what banking regulators need to think about: the people who use banks. I think that shows that political priorities are not as urgent when we're talking about smaller institutions, and then this reinforces that whole "too big to fail" idea. Most of these banks are not insolvent or even close to being insolvent. I think we actually have very few bank failures. The fact that our banking system is different from most other economies gives us the flexibility to allow those banks to innovate, experiment, and try new things, some of which may not be successful, and we can't do it with, as You know, the biggest banks in the country.

They are simply too big and too interconnected, and the economy is too dependent on their continued operation. We can't afford really big bank failures, but, you know, the economy is going to be fine if a billion-dollar bank fails.