Why U.S. Regional Banks Are Still in Crisis

Yet last month, First Republic was seized by regulators after uninsured depositors once again rushed to pull out their money, and as of today, PacWest is still teetering on the brink.

There have been signs that the nation’s regional banks are stabilizing. For one, executives at regional banks are snapping up shares in their own companies at the highest level in three years.

But Kellogg’s Gregor Matvos remains unconvinced. “The real problem is not the confidence of executives,” he says. “The real problem is the confidence of uninsured depositors.”

Insight recently sat down with Matvos, who along with his colleagues has published several influential studies on the state of the industry. Matvos explains the gravity of the situation in which regional banks still find themselves, why things may get worse before they get better, and what needs to happen to put the banking system on firmer ground. Here are some highlights from our conversation.

The underlying problems are still the same

The issues that led to the original crisis are still ongoing, Matvos emphasizes.

Silicon Valley Bank collapsed for two main reasons: first, because its assets had lost value as interest rates increased (with low-interest loans and bonds becoming less desirable to investors as higher-interest versions became available), and second, because SVB had a lot of uninsured depositors who could potentially lose out if the bank became insolvent. At the time, research by Matvos and his colleagues conservatively estimated that 186 other banks were similarly vulnerable to a bank run.

Unfortunately, neither of these problems has gone away. Interest rates are continuing to increase, eating away at the value of banks’ assets, while the government has so far declined to guarantee all uninsured deposits indefinitely.

It’s not terribly surprising that PacWest depositors are feeling a bit uneasy, says Matvos. “On the one hand, I look into the past and I see that Signature Bank’s uninsured depositors didn’t lose any money; First Republic’s uninsured depositors haven’t; the government has bailed everybody out, so I should feel okay,” he says. “On the other hand, the government’s never come out and said, ‘In the future, we will bail everybody out.’ They’ve sort of left the option open of making an example of some uninsured depositor somewhere.”

This uncertainty means that, should large numbers of a bank’s uninsured depositors get antsy all at once, a bank run could still be in the cards.

Some trends are actually getting worse

Unfortunately, things might get hairier for the banking system before they improve. That’s because a few worrisome economic trends will only put more pressure on regional banks in the coming months.

The first of these is the flailing commercial real-estate market.
About 30 percent of the assets at the nation’s 4,500 small-to-medium-sized banks are commercial real estate loans (a higher percentage than the industry average). And a lot of those loans are now maturing.

In 2017 or so, when these five-year loans were made, the real-estate market was on a tear. “So what do investors want to do?” says Matvos. “They want to borrow as much as they can.” Investors took on interest-only loans, in the hopes of rolling the final “bullet” payment that includes the principle into yet another loan. But interest rates have since skyrocketed, making new loans more expensive, while demand for office space has plummeted, with vacancies approaching 50 percent.

“If you’re holding an office building and the cash flows can’t cover if you want to refinance the loan now, you might just let it go,” says Matvos. “You might just tell the lender, congratulations, you’re now a proud owner of an office building.”

The losses for these banks aren’t enormous, but they’re not trivial either. Matvos and his colleagues estimate that, if the default rate on commercial real estate reaches 10 percent (about what it did during the Great Recession), it will cost the banking sector 80 billion dollars. “If we didn’t have the extra declines in assets [caused by the lower interest rates], banks would be totally able to absorb these losses, even the regional banks, and live happily ever after,” says Matvos. “But now they’ve lost $2 trillion plus in value already.”

Demanding depositors

The other factor poised to increase the pressure on the banking system is depositor demand for higher interest payments.

Changing banks can be a huge hassle, so depositors tend to be quite slow to move their funds, even if they could earn a higher interest rate elsewhere. But as the high rates stick around, this is starting to change. “Depositors have woken up a little bit,” says Matvos.

At least for now, the largest banks are resisting the pressure to raise rates. “If you’re JP Morgan right now, you’re still paying essentially zero percent interest rates,” says Matvos. “So JP Morgan is doing just fine, because, yes, their assets declined, but effectively what they’re paying to their depositors also declined since interest rates have gone up and they’re still paying the same amount.”

But for regional banks, which lack both the prestige and the capitalization of the biggest banks, the picture looks a bit different, he explains. Investors might already be considering moving their money. “If you are not at JP Morgan, if you’re at PacWest, you may start thinking, ‘Is this the only bank I can do business with? And If I’m going to stay, I want to be paid more than 0 percent, more than 1 percent, more than 2 percent.’ Maybe PacWest has to start offering closer to market prices.”

In other words, the most vulnerable regional banks—the ones with the antsiest depositors—are going to face the most pressure to appease those depositors with higher rates. This will further cut into their solvency.

On firmer footing

So what will it take to get regional banks on firmer footing?

Matvos and another group of colleagues recently put forth a policy proposal that would require banks to recapitalize. In the short term, they want banks to restrict equity payments to their investors and instead raise additional equity capital; in the long term, they advocate for a substantial permanent increase in capital requirements.

So far, the Fed has preferred to handle the crisis by encouraging mergers between smaller, shakier banks and larger, healthier ones. Matvos sees this strategy as “perfectly fine,” though he suspects that private infusions of capital will still be necessary to shore up the industry.

But more recently, there has been talk of increasing capitalization requirements—albeit from about 10 to about 12 percent. While this increase is not as large as Matvos would like, he believes it will help. “I’m kind of glad that somebody listened when we put out these policy proposals!” he says.

In the short term, adjusting to new capitalization requirements will be painful for the industry. But in the long term, the stricter standards will leave it—and particularly its more-vulnerable regional banks—more solvent and stable.