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

The forces that engulfed three regional lenders in March 2023 hurt tons of of smaller banks as mergers – a key potential lifeline – fell to a minimum.

As memories of last yr’s regional banking crisis begin to fade, it is easy to imagine that the industry is now on the clear. However, the high rates of interest that caused the collapse of Silicon Valley Bank and its peers in 2023 still matter.

After raising rates of interest 11 times in July, the Federal Reserve has not yet begun lowering its benchmark. The result’s tons of of billions of dollars unrealized losses based on low-interest bonds and loans remain hidden on bank balance sheets. This, combined with potential losses in business real estate, puts much of the industry in danger.

Of about 4,000 U.S. banks analyzed by the consulting firm Klaros Group282 institutions have each high levels of exposure to business real estate and large unrealized losses from rising rates of interest – a potentially toxic combination that would force these lenders to lift latest capital or engage in mergers.

The study, based on regulatory documents often known as call reportschecked for 2 aspects: banks where business real estate loans accounted for over 300% of capital, and firms where unrealized losses on bonds and loans resulted in capital levels falling below 4%.

In his evaluation, Klaros refused to supply the names of the institutions for fear of triggering a flight of deposits.

However, this evaluation only identified one company with assets exceeding $100 billion, and given the aspects included in the study, it just isn’t difficult to find out this: Community Bank of New Yorkreal estate lender that avoided disaster earlier this month with $1.1 billion available capital injection from private equity investors led by former Treasury Secretary Steven Mnuchin.

Most banks considered potentially in danger do community lenders with assets price lower than $10 billion. Just 16 firms are in the next size bracket that features regional banks – with assets starting from $10 billion to $100 billion – although they collectively have more assets than 265 local banks combined.

According to the Klaros co-founder, behind the scenes regulators are nudging banks with confidential orders to enhance capital and staffing levels Brian Graham.

“If only 10 banks were in trouble, they would all be liquidated and dissolved,” Graham said. “When hundreds of banks face these challenges, regulators must walk a tightrope.”

These banks must either raise capital, possibly from private equity sources as NYCB did, or merge with stronger banks, Graham said. That’s what PacWest used last yr; was a lender from California acquired by a smaller rival after losing deposits in the March turmoil.

Banks could also wait until the bonds mature and get off their balance sheets, but meaning years of underpayment by rivals, essentially operating as “zombie banks” that do not support economic growth in their communities, Graham said. This strategy also puts them susceptible to being swamped by mounting credit losses.

Federal Reserve Chairman Jerome Powell acknowledged losses in the business real estate market this month probably turn some small and medium-sized banks the other way up.

“I am sure this is an issue we will continue to work on for years to come. Banks will go bankrupt” – Powell he said legislators. “We’re working with them… I think it’s doable – that’s the word I would use.”

There are other signs of growing stress amongst smaller banks. In 2023, 67 lenders had low levels of liquidity – meaning money or securities may be sold quickly if needed – compared with nine institutions in 2021, Fitch analysts said in latest report. According to Fitch, their value ranged from $90 billion to lower than $1 billion.

Regulators have added more firms to their ‘Problem bank list“companies with the worst financial or operational ratings last year. According to the Federal Deposit Insurance Corp., there are 52 lenders on the list with total assets of $66.3 billion, up 13 from a year earlier.

“The bad news is that the problems facing the banking system haven’t magically disappeared,” Graham said. “The excellent news is that in comparison with other banking crises I’ve been through, this just isn’t a scenario where tons of of banks are insolvent.”

After the implosion last March of SVB, then the second-largest U.S. bank, followed by the collapse of Signature a few days later and the collapse of First Republic in May, many in the industry predicted a wave of consolidation that could help banks cope with greater funding and compliance costs regulations.

But the transactions were few and far between. Fewer than 100 bank takeovers were announced last year, According to consulting company Mercer Capital. It found that the total deal value of $4.6 billion was the lowest since 1990.

One big hurdle: Bank executives aren’t sure whether their transactions will pass regulatory requirements. Approval timelines have lengthened, particularly for larger banks in addition to regulators killed recent transactions similar to the $13.4 billion acquisition of First Horizon by Toronto-Dominion Bank.

The planned merger of Capital One and Discovery, announced in February, was quickly met with calls from some lawmakers Unit transaction.

“Banks are in this pressure cooker,” said Chris Caulfield, senior partner at West Monroe consulting firm. “Regulators are playing a bigger role in M&A opportunities, but they are also making it much more difficult for banks, especially smaller ones, to turn a profit.”

Despite a sluggish deal environment, bank leaders of all sizes recognize the need to consider mergers, according to an investment banker at one of the world’s three largest advisory firms.

The level of interviews with bank CEOs is now the highest in his 23-year career, said the banker, who asked not to be named to discuss clients.

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

Another reason to expect increased merger activity is the age of bank leaders. According to 2023 data from Spencer Stuart, a third of regional bank CEOs are over 65, above the group’s average retirement age. According to the company, this could cause a wave of departures in the coming years.

“A lot of people are tired,” said Frank Sorrentino, an investment banker at the consulting firm Stephens. “It’s a tough industry and there are a lot of willing sellers looking to do a deal, whether it’s a direct sale or a merger.”

Sorrentino was involved in January connection between First Sunday and Home, a Seattle-based bank whose shares fell last year after it cut funding. He predicts a surge in mergers by lenders with assets ranging from $3 billion to $20 billion as smaller companies look to scale up.

One deterrent to mergers is that bond and loan prices decline too deeply, which would cause the merged entity to lose capital in the transaction because losses on some portfolios must be realized as part of the transaction. This has weakened since late last year, as bond yields fell from their highest levels in 16 years.

That, combined with a recovery in bank stocks, will lead to more activity this year, Sorrentino said. Other bankers said larger deals would be more likely to be announced after the U.S. presidential election, which could emerge a new crop of leaders in key regulatory positions.

Facilitating a wave of U.S. bank mergers would strengthen the system and create competitors for megabanks, according to Mike Mayo, a veteran banking analyst and former Fed official.

“This should be an incentive for bank mergers, especially the strong ones that buy the weaker ones,” Mayo said. “Merger restrictions on the industry are the equivalent of the Jamie Dimon Protection Act.”