Where cracks may appear in the banking sector without more mergers and acquisitions

The forces that consumed 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 the memory of last year's regional banking crisis begins to fade, it's easy to believe the industry is safe. But the high interest rates that caused the collapse of Silicon Valley Bank and its peers in 2023 remain in play.

After raising rates 11 times through July, the Federal Reserve has yet to begin cutting its benchmark index. As a result, hundreds of billions of dollars of unrealized losses on bonds and low-interest loans remain buried in banks' balance sheets. That, combined with potential losses in commercial real estate, leaves sectors of the industry vulnerable.

Of about 4,000 U.S. banks analyzed by consulting firm Klaros Group, 282 institutions have high levels of exposure to commercial real estate and large unrealized losses from rising rates, a potentially toxic combination that may force these lenders to raise fresh capital. or carry out mergers.

The study, based on regulatory filings known as call reports, looked at two factors: banks where commercial real estate loans accounted for more than 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 inciting runs on deposits.

But in this analysis there is only one company with more than 100 billion dollars in assets and, given the factors in the study, 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 community lenders with less than $10 billion in assets. Only 16 companies are in the next size group that includes regional banks (between $10 billion and $100 billion in assets), although they collectively own more assets than all 265 community banks combined.

Behind the scenes, regulators have been pressuring banks with confidential orders to improve capital levels and staffing, according to Klaros co-founder Brian Graham.

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

These banks need to raise capital, probably from private capital sources like NYCB did, or merge with stronger banks, Graham said. That's what PacWest turned to last year; The California lender was acquired by a smaller rival after it lost deposits in the March tumult.

Banks can also choose to wait for bonds to mature and come off their balance sheets, but doing so means years of earning less than their rivals, essentially operating as “zombie banks” that don't support economic growth in their communities, Graham said. That strategy also puts them at risk of being overwhelmed by mounting credit losses.

Federal Reserve Chairman Jerome Powell acknowledged this month that losses in the commercial real estate sector are likely to cause some small and midsize banks to fail.

“I'm sure this is an issue we'll be working on for years to come. There will be bank failures,” Powell told lawmakers. “We're working with them… I think it's manageable is the word I would use.”

There are other signs of growing stress among smaller banks. In 2023, 67 lenders had low levels of liquidity (that is, cash or securities that can be sold quickly when needed) versus nine institutions in 2021, Fitch analysts said in a 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 “Problem Banks List” of companies with the worst financial or operating ratings over the past year. There are 52 lenders with a combined $66.3 billion in assets on that list, 13 more than a year earlier, according to the Federal Deposit Insurance Corporation.

“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've worked on, this is not a scenario where hundreds of banks are insolvent.”

After SVB's implosion last March, the second-largest failure of a U.S. bank at the time, followed by Signature's bankruptcy days later and First Republic's in May, many in the industry predicted a wave of consolidation that could help banks deal with increased financing. and compliance costs.

But agreements have been few and far between. According to advisory firm Mercer Capital, fewer than 100 bank acquisitions were announced last year. The total value of the deal, at $4.6 billion, was the lowest since 1990, he concluded.

One big problem: Bank executives aren't sure their deals will pass regulatory muster. Approval deadlines have lengthened, especially for larger banks, and regulators have canceled recent deals, such as the company's $13.4 billion acquisition of First Horizon. Toronto-Dominion Bank.

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

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

Despite the slow deal environment, leaders at banks of all sizes recognize the need to consider mergers, according to an investment banker at a top three global advisory firm.

Conversation levels with bank CEOs are now the highest in his 23-year career, said the banker, who requested anonymity to discuss clients.

“Everyone is talking and there is a recognition that consolidation has to happen,” the banker said. “The industry has changed structurally from a profitability standpoint, due to regulation and because deposits are now something that will never cost zero again.”

Another reason to expect greater merger activity is the age of banking leaders. A third of regional bank CEOs are over 65, beyond the group's average retirement age, according to 2023 data from executive search firm Spencer Stuart. That could trigger a wave of exits 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 Stephens. “It's been a difficult industry and there are many sellers willing to transact, whether it's a full sale or a merger.”

Sorrentino was involved in the January merger between FirstSun and HomeStreet, a Seattle-based bank whose shares plummeted last year after a funding squeeze. He predicts an increase in merger activity from lenders between $3 billion and $20 billion in assets as smaller companies look to grow.

One deterrent to mergers is that bond and loan writedowns have been too deep, which would erode the capital of the combined entity in a deal because losses in some portfolios must be realized in a transaction. That has declined since late last year when bond yields fell from 16-year highs.

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

Clearing the way for a wave of U.S. bank mergers would strengthen the system and create challenges for megabanks, according to Mike Mayo, the veteran banking analyst and former Federal Reserve employee.

“It should be a safe bet for bank mergers, especially for the strong to buy the weak,” Mayo said. “Merger restrictions in the industry have been the equivalent of the Jamie Dimon Protection Act.”