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

Brendan Mcdermid | Reuters

The forces that engulfed three regional lenders in March 2023 have ravaged hundreds of smaller banks as merger activity – a key potential lifeline – has fallen to a minimum.

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

After raising interest rates 11 times through July, the Federal Reserve has yet to begin cutting its key interest rate. The result is hundreds of billions of dollars unrealized losses on low-interest bonds and loans remain hidden on the banks’ balance sheets. Combined with potential losses in commercial real estate, this leaves parts of the industry vulnerable.

Of about 4,000 U.S. banks analyzed by a consulting firm Klaros Group282 institutions have both high exposure to commercial real estate and large unrealized losses from rising interest rates – a potentially toxic combination that could force these lenders to raise fresh capital or engage in mergers.

The study is based on regulatory documents known as Call reportsexamined two factors: banks where commercial real estate loans accounted for over 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 a deposit storm.

However, only one company with more than $100 billion in assets was found in this analysis, and given the study’s factors, it is not difficult to determine: New York Community Bankthe real estate lender that averted disaster with $1.1 billion earlier this month Capital injection by private equity investors led by former Treasury Secretary Steven Mnuchin.

This is the case for most banks that are considered potentially vulnerable community lenders with assets of less than $10 billion. Only 16 companies are in the next largest size class, which includes regional banks—between $10 billion and $100 billion in assets—even though they collectively hold more assets than the 265 community banks combined.

According to Klaros co-founder, regulators have been giving banks confidential instructions behind the scenes to improve capital and staffing levels Brian Graham.

“If there were just 10 banks that were in trouble, they would all have been torn down and dealt with,” Graham said. “When hundreds of banks face these challenges, regulators have to walk a certain balancing act.”

These banks will either need to raise capital, likely from private equity sources, as NYCB has done, or merge with stronger banks, Graham said. PacWest resorted to this last year; was the Californian lender acquired taken over by a smaller competitor after it lost deposits during the March turmoil.

Banks could also choose to wait for the bonds to mature and then exit their balance sheets. But that means they will underpay their competitors for years and essentially operate as “zombie banks” that don’t support economic growth in their communities, Graham said. This strategy also carries the risk of being swamped by mounting credit losses.

Powell’s warning

Chairman of the Federal Reserve Jerome Powell acknowledged this month that there are losses in commercial real estate are likely cause some small and medium-sized banks to capsize.

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

There are other signs of increasing stress at smaller banks. In 2023, 67 lenders had low liquidity – meaning cash or securities that can be sold quickly if needed – compared to nine institutions in 2021, Fitch analysts said in a report Current report. According to Fitch, their assets ranged from $90 billion to less than $1 billion.

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

“The bad news is that the banking system’s problems haven’t magically disappeared,” Graham said. “The good news is that compared to other banking crises I have experienced, this is not a scenario where hundreds of banks are insolvent.”

‘pressure cooker’

After the implosion of SVB last March, it was the second-largest US bank failure at the time, followed by Signature After the failure a few days later and that of First Republic in May, many in the industry predicted a wave of consolidation that could help banks deal with higher funding and compliance costs.

But there were few deals. Last year, fewer than 100 bank takeovers were announced, after to the consulting firm Mercer Capital. The total value of the deal was $4.6 billion, the lowest since 1990, it said.

A big problem is that bank executives are unsure whether their businesses will pass regulatory scrutiny. Approval timelines have lengthened, particularly for larger banks, and regulators have also lengthened killed recent deals, such as the $13.4 billion acquisition of First Horizon Toronto Dominion Bank.

A proposed merger between Capital One and Discovery announced in February immediately drew calls from some lawmakers block the transaction.

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

Banking leaders of all sizes are recognizing the need to consider mergers despite the slow deal environment, according to an investment banker at one of the world’s top three consulting firms.

The level of conversation with bank CEOs is now the highest in his 23-year career, said the banker, who asked to remain anonymous to discuss clients.

“Everyone is talking and there is an understanding that consolidation needs 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 cost zero again.”

Aging CEOs

A deterrent to mergers is that discounts on bonds and loans are too high, which would result in a capital loss to the combined company in a transaction, as losses on some portfolios must be realized in a transaction. That has eased since the end of last year as bond yields fell from their 16-year peak.

That, along 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 result in a new group of executives taking on key regulatory roles.

Paving the way for a wave of U.S. bank mergers would strengthen the system and create challengers to the megabanks, said Mike Mayo, the veteran banking analyst and former Fed official.

“When it comes to bank mergers, it should be important that the strong buy the weak,” said Mayo. “The industry merger restrictions were the equivalent of the Jamie Dimon Protection Act.”

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