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Hundreds of small and regional banks across the U.S. are feeling stressed. More than 280 banks face the dual threat of commercial real estate loans and potential losses tied to higher interest rates. There's no doubt in my mind there's going to be more bank failures Or at least, dip below their minimum capital requirements. There will be bank failures. But, this is not the big banks. Rapid interest rate hikes can mean borrowers suddenly face more expensive loan payments, and if they can't afford to pay up, they may default on their loans. A record $929 billion worth of loans are coming due, aka maturing in 2024, driven by "mass extensions" of loans originally due in 2023. Regulators are working behind the scenes with potentially at-risk lenders. They're issuing sort of confidential under the radar reports, saying you got to raise your capital. We'll see a lot fewer bank failures than we would otherwise if we're successful in attracting private capital to recapitalize these banks These are banks that probably need to raise capital, or they could try to get acquired by a stronger bank. However, banking sector acquisitions have dwindled. These stressed banks could have big implications for the U.S. economy. It's been one year since the collapse of Silicon Valley Bank... Of course, we're seeing cracks form once again a year later. Both major and regional bank indexes are still struggling since 2023's bank failures. I think most of them are just fine. But, confidence is everything in banking. If people start losing confidence then even the healthy banks can be adversely impacted. Here's why hundreds of small banks may be at risk of failure and how insolvency can be avoided. The U.S. has thousands of banks. There are about 4,600 banks in the United States. But in most developed economies in the world, there aren't regional and community banks. Approximately 4,000 banks in the U.S. are small banks, also known as community banks. If you add up the collective assets of those 4,000 banks, small banks control roughly the same value of assets as America's largest bank, J.P. Morgan Chase, with $3.2 trillion of assets. Now, the stress is really moving to the community bank category. And those are between $1 and $10 billion in assets. Those are the great bulk of the institutions that are going to be, you know, facing this stress. The Klaros Group analyzed 4,000 banks, screening regulatory call report filings for banks with over 300% of capital in commercial real estate loans and potential losses tied to interest rates. I'm Brian Graham. I'm a founder and partner in the Klaros Group. We thought it was important to focus on how they measured up on those two macroeconomic factors that are at work. 282 US banks are at risk, with nearly $900 billion in total assets. The majority of those banks are smaller lenders with less than $10 billion in assets each. 16 of those banks are larger, with anywhere from 10 to $100 billion in assets. There's only one bank with over $100 billion in assets. You know, one point of this analysis is to say, look across the universe of 4,000 banks. Where are the issues going to be? They are going to be in the middle to small size banks, which is, by its nature, less systemic. I think the issue is that a lot of these smaller banks support communities away from the coast. You're essentially hamstringing the the economic development in those communities. First of all, even if they're smaller banks, the communities that rely on them certainly care about them. The US has about 130 banks that are considered regional banks, and collectively they control just under $3.1 trillion in assets. The larger regional banks... They're a really important source of credit for smaller and medium sized businesses, local governments, nonprofits. Without regional lenders, more businesses may have to turn to Big Banks for services that may be more expensive and less personable, and they may not like their options. They provide competition for the really large, you know, mega banks, the multi-trillion 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 aren't insolvent or even close to insolvent. They're just stressed. But it doesn't mean that communities and customers don't get hurt by that stress. The natural reaction is to not invest in the next branch or technological innovation, or to make the next hire. It just hurts the community in a different way, and it hurts it more kind of subtly and gradually and over time than a bank failure. Directly, it's no consequence if they're below the insured deposit limits, which are quite high now - $250,000. That means if a bank insured by the Federal Deposit Insurance Corporation, also known as the FDIC, goes under, all depositors will be paid "up to at least $250,000" per individual per bank, per ownership category. The FDIC has really got a strong record on this, so people should not worry. The U.S. has the largest commercial property market globally, and banks underwrite the majority of commercial real estate loans. If you think about the banking industry overall, there are four basic types of loans:. Consumer loans. CNI loans, which are essentially loans to companies 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 that they just made a bad decision and jumped into the commercial real estate with both feet. And, it's more that they just don't have the scale to compete with the larger banks in the country in consumer lending or in residential mortgage or in commercial and industrial lending. And, that leaves them with a higher concentration and exposure to commercial real estate. The markets in general, are poking the banks on their exposures, you know, how are they being managed, what are some of the stresses that they're thinking about? And most probably... Most importantly, how are they reserving for those potentials? When the Federal Reserve raises rates, commercial real estate loan payments can become more expensive for borrowers. If borrowers can't afford payments, they may default on their loans. Federal Reserve Chairman Jerome Powell has candidly said look, there are going to be bank failures. It's going to happen. We have identified the banks that have high commercial real estate concentrations, and we are in dialogue with them around, you know, do you have your arms around this problem? Do you have enough capital? Are you being truthful with yourself and with your owners? The Federal Reserve hiked interest rates 11 times since March 2022. Interest rates being much higher than they were a couple of years ago, means that the value of fixed rate assets has gone down very significantly, and that's an embedded loss going to show up one way or another over time. And therefore, there are a ton of unrealized losses on banks held to maturity portfolio in terms of bonds and also the mortgages that they issued that were all done under a low interest rate regime. And so those are unrealized losses. They're sitting there on the balance sheets. This is because bonds issued when interest rates are higher will have higher returns for investors. If you bought a bond that's paying 3% and interest rates are now 6%. Your 3% bond is now worth a lot less. What that does do is it creates pressure on what's called the net interest margin. So, as interest rates go up, banks may need to pay more and more interest on their deposits. But, they still have a lot of lower yielding loans and securities. So, that really narrow the margin. That's the way banks, traditional banks, make money. They take deposits and pay one rate and lend it at a higher rate. But when rates rise, that dynamic can become inverted. When a bank sells assets that have decreased in value, those losses become realized. The only thing that makes those losses unrealized is the banks haven't sold them yet, so they're still on their books, and they're still hoping that interest rates will go back down to zero. And the whatever the value loss is will go away. It's classic interest rate risk management and good banks, and good bank executives, should know how to manage it. And I think most are. The Fed is being cautious about interest rate changes in 2024. However, a rate cut may not change how much stress banks are facing. Hope is never a plan. If you're a stressed bank in this market environment, your choices are pretty simple. You can either hunker down and basically shrink in order to try and match whatever capital it is you do have. I think a lot of institutions are likely to take that path. Regulators do allow banks to work with their borrowers 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 nonetheless, that's usually better than a borrower defaulting, which can be very expensive 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 whole bunch of government bailouts, because the problem isn't a bunch of insolvent banks. The problem is a bunch of stressed and undercapitalized banks. What's the purpose of the capital markets if not to, you know, provide capital? Take New York Community Bank as an example. The New York Community Bank did not fail. New York Community Bancorp because the shares they are rising after the bank raised more than $1 billion from a group of investors... They pumped capital into that institution and hopefully positioned it to be successful and to serve its communities better than they would have if they were still in hunker down mode. Putting $1 billion of capital into the balance sheet. It really strengthens the franchise and whatever issues they are in, the loans will be able to work through. Or, stronger banks can acquire the weaker banks. Now, the issue there that we know is that last year was actually a 40-year low in terms of bank M&A. It was the lowest since 1990, even before an inflation-adjusted basis. There were fewer than 100 bank acquisitions in 2023. The total value of acquisition deals made was the lowest since 1990, at $4.6 billion. We don't expect to see a lot of M&A activity for the foreseeable future. I think the merger math probably doesn't really work for most banks right now in terms of lower equity valuations. So, it's hard to get a buyer and seller to agree on price right now. More importantly, what we're also seeing is a regulatory push back on M&A. Some regulatory institutions are considering stricter scrutiny over merger and acquisition deals. The Justice Department has made public statements about this. The SEC put out a proposal which would raise the bar for bank M&A, particularly if you kind of cross over that the $50 billion mark. The FDIC put out a draft statement of policy on M&A. The guidance suggested there be really a lot of scrutiny of anything over $100 billion. Deals of all sizes are facing scrutiny. For example, regulators recently refused approval of Toronto-Dominion bank's $13.4 billion deal to acquire First Horizon Bank. We have a problem of concentration in the banking industry, but it's not the regional bank level. I'm worried about concentration at the mega bank level. I think there's some really legitimate points that that the regulators are raising about making sure that any mergers amongst the largest banks in the country are subject to some pretty strict scrutiny. Makes sense to me. I don't think that's true for those smaller banks that are struggling for survival. Those just don't raise the same macroeconomic antitrust, systemic stability. I do have a little concern on the regulatory responses, whether they intended it this way or not, I don't know, but are being interpreted, and I think somewhat logically so, being interpreted as discouraging M&A. So, I think clarifying that M&A with a healthy bank that would result in a stable, unified structure... I think making clear that those are welcome and encouraged. I think that would be good. I don't know if they're going to do that. They seem to be going the opposite way, but you want to be encouraging it now. That's what I would like to see. Regulators say they are working with bank leadership to address concerns. I think it's manageable is the word I would use. But it's you know, it's a very active thing for us and the other regulators. And it will be for some time. You have regulators who are very aware of this situation. They're now on top of it. And they're issuing matters requiring board attention to these institutions, and they hope to be able to cajole them into raising capital, to selling some assets to improve their capital situation, and to do so in a way that doesn't cause anything systemic. Even if a stressed bank raises capital or hunkers down, researchers expect some failures on the horizon. These are real economic losses and challenges, and we'll see some, but I don't think we'll see a massive wave of bank failures. We'll see a lot fewer bank failures than we would otherwise. If we're successful in attracting private capital to recapitalize these banks, and for at least the smaller banks, permitting some M&A and consolidation, which would in turn attract more private capital, that certainly would serve to reduce the number of any bank failures we'll have. Consider the timeline of the Great Financial Crisis and its fallout. It took about two years from 2008, so you didn't really see the peak losses and delinquencies till about 2010. And we think the same thing will be true this time as well, which is this is probably going to play out over the next, probably, two years. So, we'll probably still be talking about this in 2025 and maybe even into 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 a lot of bank failures, and so we kind of are conditioned to expect stress in the banking system will be defined by a bunch of bank failures. But during the Great Financial Crisis, when it was those big banks. When they were in trouble, we didn't have any trouble going to the Hill and raising raising heck. At the end of the day, that's who bank regulators need to be thinking about: the people who use the banks. I think that kind of shows that the policy priorities are not as urgent when we're talking about smaller institutions, and then this reinforces this whole "too big to fail" idea. Most of these banks aren't insolvent or even close to insolvent. I think we actually have too few bank failures. The fact that our banking system is different from that of most other economies gives us the flexibility to allow those banks to innovate and to experiment and to try new things, some of which may not be successful, and we can't do that with, you know, the biggest banks in the country. They're just too large and too interconnected, and the economy is too dependent on their continued functioning. We can't afford really, really big bank failures, but, you know, the economy is going to be just fine if a $1 billion bank fails.