Increased scrutiny on bank soundness could signal a bumpy ride

Fasten your seatbelts for what could be a bumpy ride as we close out 2023. We cruised into the summer with the Federal Reserve temporarily pausing interest rate increases. As the weather and the market mood improved, the stock market rallied, helping us enjoy the brief break from the market volatility, even if the future market moves remained uncertain.

After Silicon Valley Bank failed in March, the Fed turned to another inflation-fighting tool: their bank oversight powers. Then, in May, the Fed announced they were increasing bank capital requirements by 20 percent. That, coupled with increased scrutiny on bank soundness, led banks to reduce lending, which created broad-based deflationary impacts while also bolstering the stability of the banking system.

During the recession of 2008-2010, financial institutions deemed “too big to fail” were viewed negatively as they were given capital infusions by the Federal Reserve to ensure the banks’ survival. Today, “too big to fail” is viewed differently as the largest banks and insurance companies are well capitalized and viewed as bulwarks to current market volatility as we saw in the sale of SVB assets to JPMorgan.

As banks strategize on meeting the 20 percent increase in required capital and reduce loan portfolio risk, they are left with difficult choices. Under normal circumstances, banks could increase capital through a combination of tactics including deposit raising, issuing new stock, or encouraging loan payoffs/loan sales.

However, the cost for smaller banks to attract new deposits has skyrocketed as customers have moved their deposits to the “too big to fail” banks. The cost of issuing new stock (what Silicon Valley Bank tried to do prior to failing) sends a dangerous signal to the market of material weakness for a bank and is too dilutive to the value for existing shareholders, especially after bank stocks plummeted 10-50 percent this past spring.

The most attractive option for banks is to shrink their loan books through decreased lending, accelerated loan payoffs and selling the existing loans on their books to third parties, as Pacific Western Bank did in May. This approach should have a deflationary impact on our economy while also decreasing risk in the banking system.

The crux of the bank issues of capital reserves and balance sheet risk appears to lie in their commercial real estate exposure. Regional banks hold over 40 percent of U.S. commercial real estate debt, by far the largest holder of commercial real estate debt. The four major commercial real estate categories are office, retail, industrial and multifamily. The office sector is extremely challenging while retail has been retrenching for years. Industrial and multifamily have strong underlying fundamentals.

Given the likely discounts needed to sell their debt on office properties, it will be tough for banks to sell office loans to raise bank capital. It is more likely for banks to build capital through loan paydowns and loan sales on industrial and multifamily properties as the maturing loans will require more equity from the property owners due to decreased real estate values.

Expect to see significant pressure on borrowers to pay down or pay off their loans as well as more robust loan sales toward the end of 2023 as banks work to clean up their loan credit quality and build up capital reserves to satisfy Federal Reserve requirements. Depending on how severe the credit quality issues are for banks, it is possible we will see an increase in bank merger activity, especially if bank earnings are hit hard enough and the path to increasing capital reserves by 20 percent looks challenging.

So, strap in for the ride this quarter, and prepare for a bumpy ride the second half of 2023. ●

Daniel Walsh is Founder & CEO of Citymark Capital

Daniel Walsh

Founder and CEO