Regional banks are the backbone of America

by Zain Jaffer

Actor Jimmy Stewart played small town banker George Bailey in the classic 1946 film “It’s a Wonderful Life.” Unfortunately, the images that most people have of bankers these days are of Mike Douglas playing cunning banker Gordon Gecko in Wall Street, and similar films like The Big Short and Margin Call. Regional small banking isn’t really appreciated that much these days in the public eye.

Whenever a major Wall Street bank acquires a regional bank to become bigger and more capitalized, the merger might work to ensure that its capital ratio is several times bigger than possible sudden outflows of deposits. After all, it has been reported that a significant number of Silicon Valley Bank (SVB) depositors pulled out their money in just a few hours online. With the recent First Republic Bank closure, it appears that the situation has not been fixed.

The unfortunate situation here is that the Fed hikes have put the regional banks literally on the squeeze. Bank margins now are extremely paper thin. Their assets are valued low, their cost of capital is high. Their depositors now suddenly realize they can get 5% on a treasury bond or in the money market as opposed to a one percent or less bank savings rate. They can leave at the speed of a click, and there are very few loan clients wanting to take on high interest loans.

Banks are being hammered from many fronts because of the higher Fed interest rates, an unprecedented almost 500 basis point rise in a span of a few months. Because they had acquired their long term ten year bonds, MBS, and other financial asset instruments when the CARES Act put money in the hands of citizens who deposited a lot of it, these were older lower interest bonds. Unfortunately newer bonds available now from the Treasury are yielding higher, thus their assets when marked to market are worth less than the face value. In the case of SVB, they had to sell their older bonds prematurely and declare a $1.8bn mark to market loss in their books just to have cash to service their depositors.[1]

The lower value of their bonds would not have been a problem for the banks if their original plan to hold it up to full maturity was realized. Unfortunately, depositors are pulling out their money and putting it into money market funds with the newer higher yield treasuries. Data from the Federal Reserve Economic Data (FRED) shows that commercial deposits are going down.[2]

Recently however, some banks have started to offer higher savings rates just to keep their customers happy. Even Apple, with its $2T market cap, has started to position itself in financial services.

Another problem is their defaulting loans from individuals and businesses who can no longer cope with higher mortgage, car loan, and business loan payments because their income and business revenues have fallen short, and the monthly amortization due on their loan has become higher, especially if they have adjustable rate loans.

Real estate is another problem. At a 4-5% overnight lending rate from the Fed, or even if they borrow from the reverse repo market, many banks find it hard to make loans since their clients have been used to many years of low rates. Basically their higher cost of capital makes it almost impossible these days to have a good margin on the loans they make to clients. Spreads are extremely thin if they exist.

Many developers, especially those who have been developing commercial real estate, have their own problems. Because of the Work from Home and Quiet Quitting trends in the workplace, many urban office spaces are actually empty or only partly used in some large US cities. Although leases might still be currently paid on certain office spaces, some tenants may have already preterminated, downsized their floor space, or are no longer planning to renew, especially with a recession looming on the horizon.

Some developers are thinking of converting some of these to residential or mixed use buildings, but aside from zoning changes, will also involve costs, and is not really a wise move in most cases. Besides, if people can’t get bank loans, then there won’t be too many interested buyers except for those with excess cash on hand.

Similarly for retail shopping spaces like malls, this sector has really taken a hit from online shopping that people grew to depend on during the pandemic.

This puts the banks in a dilemma if they have to foreclose these properties that are partly empty. They will end up holding real estate that no one needs, that can only be sold at low market rates. Again, only in certain areas.

It is good that the US Government stepped in with its low interest Bank Term Funding program in March 2023 to allow banks to loan from the Fed based on the face value, and not the lower market value, of the bonds they are holding.[3] This one year loan, plus the guarantees from the FDIC that they will guarantee deposits in banks who encounter the same issues, has calmed the situation somewhat. The Bank Term Funding program was designed so that banks will not need to sell off their older lower yielding bonds, and instead hold these to full maturity as originally intended.

If we lose these regional banks, it will definitely affect our Gross Domestic Product (GDP) because much of Main Street, like the individuals and small and medium sized companies of Middle America, deals with them, and not with Wall Street banks who typically only handle the bigger syndicated loans of large Fortune 500 companies.

Clearly if the regional banks don’t make it, there will be big problems ahead for most of America.



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