One Year in Regional Banking

Editors’ Note: MarketMinder doesn’t make individual security recommendations. The below merely represent a broader theme we wish to highlight.

Has it “already” been a year, or has it “only” been a year? We can’t quite decide, as we mark the one-year anniversary of Silicon Valley Bank’s (SVB’s) failure, which touched off last year’s regional banking freakout. In some ways it feels like yesterday; in others longer, given all that has transpired since. One thing that hasn’t transpired: A full-blown financial crisis or any broad, national fallout. Instead, reality has largely proven what we said at the time, that SVB’s problems were unique, not emblematic of even the regional banking industry writ large, much less the financial system, and markets would likely move on soon enough. They have, with regional bank stocks passing pre-SVB levels late last year and the S&P 500 up 34.8% through Friday’s close.^[i] The saga isn’t quite over, as there is still a chance regulatory changes could bring some unintended consequences—something we are watching for. But it shows the financial system is plenty strong enough to withstand problems at individual banks, limiting the overall market risk.

We covered SVB’s idiosyncrasies in great detail at the time, so we won’t bore you with a full rehash. But in short, it catered to Silicon Valley’s startups, their venture capital (VC) backers and friends and family thereof, which meant it relied to a great degree on large (uninsured) deposits. It also owned a lot of US Treasury bonds, which it planned to hold to maturity—negating the need to mark them to the current market value. This was fine when interest rates were low. But as rates rose, depositors started getting antsy about the large unrealized losses on its balance sheet—and the potential for SVB to have to realize those losses as the bank’s cash-burning Tech startup clients drew down their deposits. Those fears eventually came true when SVB announced a Treasury bond firesale. Though it also subsequently announced a capital raise, it was too late, and a classic bank run brought it down. This happened at the same time New York’s Signature Bank failed as crashing crypto wrecked its balance sheet, giving investors the impression a bicoastal bank contagion would go nationwide. The Fed, as it does, responded with a liquidity facility for regional banks—the Bank Term Funding Program (BTFP)—adding to the perception that there was a nationwide problem.

But those perceptions were off the mark. The BTFP doled out plenty of money, but a granular look at regional Fed data showed use was concentrated on the West Coast and New York. Fellow West Coast regional bank First Republic eventually failed in May, a victim of its own unique business practices (in this case, doling out mega low-rate mortgages for its wealthy clients’ trophy real estate). But this, along with Credit Suisse’s coincidental but not totally related failure, was about the extent of the damage. There was no contagion. Depositors didn’t flee regional banks. Lending slowed but didn’t tank. BTFP turned from a funding lifeline to an arbitrage tool that the Fed just ended early. From their post-First Republic low on May 11 through yearend, regional banks jumped 42.3% in price terms.^[ii]

They have slipped since, largely because another bank is dealing with some idiosyncratic issues, resurrecting last year’s concerns. The bank in question is New York Community Bancorp (NYCB), which absorbed Signature Bank’s assets last year and thus inherited some of its troubles. There is a lot of talk about it being the canary in the coal mine for commercial real estate’s well-documented woes, but that doesn’t hold up, in our view. NYCB’s commercial exposure isn’t the widely feared empty offices, but Manhattan’s rent-controlled units, whose owners are (predictably) having trouble servicing debt as their costs rise while their revenues don’t. That is a local, institution-specific problem, not a portent for regional banks’ commercial property exposure elsewhere. Just as the regional banking system survived niche West Coast woes last year, it can get past the East Coast blues now.

In our view, the broader risk for the sector hasn’t changed over the past year. To us, it isn’t contagion. Rather, it is that, in trying to prevent a repeat, regulators sow the seeds of a new problem down the line. One way this could happen: a crackdown on hold-to-maturity (HTM) accounting rules. Since regulators amended mark-to-market accounting rules after 2007 – 2009’s global financial crisis, banks no longer have to mark every asset on their balance sheet to the most recent comparable sale price. They must do this for assets designated as available for sale (AFS) on their balance sheet, but not for those they plan to hold until they mature, collecting interest along the way. For HTM assets, banks can mark them at face value. The purpose here is a good one: preventing volatility in illiquid assets banks don’t intend to sell from imperiling banks’ capital levels, and it fixed the problems with mark-to-market accounting that fomented 2008’s panic. But after SVB’s Treasury bond misadventures, there were rumblings about a change.

So far, that change hasn’t come. The Fed hasn’t concocted new rules for small regional banks, and changes to HTM accounting were absent from last year’s proposals for the final round of Basel III implementation. To us, the hesitance is sensible, given the past year has largely proven a regulatory crackdown unnecessary. The system worked as it should, absorbing a failure and moving on. Now other banks will pay to replenish the FDIC’s resolution fund out of profits earned.

But the rumblings continue, not least in the many One-Year-On retrospectives. We saw some chatter about tying regional banks’ freedom to use HTM accounting with their level of exposure to uninsured deposits, which are theoretically faster to flee in a crisis. It all seems a bit arbitrary, places more faith in regulators than we think history merits and appears ripe for unintended consequences. Now, this chatter doesn’t mean a rule is forthcoming or even in the works, but it wouldn’t shock us if the associated uncertainty hangs over regional banks for a while.

But this seems like an industry-specific structural issue, not a cyclical economic or market issue or sign of problems in the banking system overall. Actually, it appears quite healthy. The latest aggregate data available from the New York Fed show the US banking system’s collective common equity tier 1 (CET1) capital was 13.12% of risk-weighted assets at Q3 2023’s end, well above the pre-2008 average.^[iii] Held-to-maturity securities’ share of banks’ total assets was down a smidge. Profitability metrics looked fine. Non-performing loans remained near generational lows despite a slight uptick in commercial real estate loan troubles (which the smallest banks turned out to be least exposed to). For the big banks, commercial real estate exposure is a fraction of profits. And small banks’ deposits have gradually recovered from their March 2023 decline, which was mostly a mathematical figment of Signature’s deposits moving off the books when it was resolved.^[iv]

In the end, markets handled this in the most rational fashion possible: They quickly and correctly diagnosed SVB and its fallout as an isolated issue that raised some questions for regional banks but didn’t otherwise threaten the financial system or the economic expansion at large. Cold and efficient, proving keeping a cooler head is a better choice than succumbing to fear.