In the aftermath of the 2008 financial crisis, politicians and financial institutions alike stressed the importance of comprehensive financial sector reform. Two controversial regulations, the 2010 Dodd-Frank Act and Basel III international regulatory framework were both implemented with the goal of making the banking system safer. At the center of these reforms was a drive to strengthen banks’ balance sheets by requiring banks to maintain higher levels of capital, hold higher quality assets, submit to regular stress tests and write "living wills" that detail how they can be wound down.
In May 2018, some of these safeguards were rolled back; the Dodd-Frank rollbacks did not impact the nation’s largest banks, which are still subject to the entire law. However, raising the threshold at which banks are considered systemically risky and subject to stricter oversight from $50 billion to $250 billion resulted in less stringent regulation for thousands of small and medium-sized banks.[1]
Today, tighter regulation is likely coming again, with a particular focus on managing interest rate and liquidity risk, affecting both sides of a bank’s balance sheet. On the liabilities side, banks would need more long-term liabilities that can be converted into equity in the event of stress, which will likely drive up the cost of capital. On the assets side, banks would need to hold sufficient high-quality liquid assets (HQLA), such as cash and U.S. securities, to fund the daily cash outflows in a hypothetical 30-day scenario. The pressure on both sides of the balance sheet suggests a squeeze on margins and profitability.
The current administration specifically urged banking authorities to tighten regulation of mid-sized banks, which it said could be pushed through without support from a split Congress. Furthermore, banks with between $100 billion and $250 billion in assets should hold more liquid assets, increase their capital, submit to regular stress tests and write "living wills." The White House's push for more regulation came three weeks after the collapses of Silicon Valley Bank and Signature Bank triggered market turmoil.[2]
Since the spring of 2023, banks have had time to guard themselves against another scare in the banking sector. Some have sold off bond and loan portfolios to shore up their balance sheets. Others have indulged in some accounting alchemy whereby bonds previously held at fair value were reclassified as assets held to maturity. Suddenly, losses on portfolios disappeared.[3]
Cause for worry
According to the chair of the Federal Deposit Insurance Corporation (FDIC), there were $620 billion of such unrealized (or paper) losses on U.S. bank balance sheets in early March 2023. Further, some believe the figure is understated, with two recent estimates suggesting the outstanding losses could be as much as $1.7 trillion.[4]
Treasury Secretary Yellen holds another view saying risks primarily lie in the loans smaller banks have extended for office buildings. A shift toward remote work has undermined the value of many office buildings, while higher interest rates have increased the cost of many commercial mortgages. That has left many landlords at risk of default, which could in turn create trouble for the smaller banks that hold much of that mortgage debt.[5]
Yellen has indicated that the government may accommodate bank mergers, especially small to mid-sized banks. Share prices for the sector are about one-third lower than at the end of 2022. Bank combinations are usually thought to bring lower costs through efficiency and better management. However, some smaller banks have said they are paying more on savings accounts after the Federal Reserve began raising rates last year.
Summary
How will all of this impact the banking industry? Potentially risky balance sheets, likely greater regulatory oversight as pushed by the current administration and higher funding costs, make for abundant bargain hunting among small-midsize banks—but at what risk? Right after the spring defaults/rescue, short interest in regional banks spiked. While it is still sizeable, today, investor chat suggests an increased buying opportunity. The S&P regional bank industry has shown gains in the past month with the KRE and DSPT up 5% and 13%, respectively.[6]
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[2] https://www.reuters.com/markets/us/white-house-pushes-stronger-regional-bank-rules-without-congress-2023-03-30/
[3] https://www.morganstanley.com/ideas/regional-banking-regulations-2023
[4] https://www.thomsonreuters.com/en-us/posts/investigation-fraud-and-risk/us-banks-problems/
[5] https://www.wsj.com/articles/yellen-says-more-bank-mergers-likely-this-year-96f69e73?mod=article_inline
[6] https://www.wsj.com/articles/the-era-of-easy-deposits-is-over-for-main-street-banks-7926fb4?mod=article_inline
