The crazy weekend in late April, when the biggest bank in the country took over the most troubled regional bank, marked the end of one wave of problems and the beginning of another.
After JPMorgan Chase CEO Jamie Dimon won the bid for First Republic, a lender to wealthy coastal families with $229 billion in assets, he said to investors, “This part of the crisis is over.” This was a relief after weeks of stomach-churning instability.
But even though the dust has settled after the government took over a number of failed mid-sized banks, the same things that caused the regional banking crisis in March are still at work.
Rising interest rates will make banks lose more money on the stocks they hold and make savers pull money out of their accounts, which hurts the main way these businesses make money. Banks are just starting to see losses from business real estate loans and other loans, which will make their bottom lines even smaller. After the failure of Silicon Valley Bank showed supervisory flaws, regulators will focus on banks in the middle size range.
What’s coming will probably be the biggest change in the way American banks work since the financial collapse of 2008. In the next few years, the market or regulators will force many of the country’s 4,672 lenders to join bigger banks, said a dozen executives, advisors, and investment bankers who spoke with CNBC.
“There’s going to be a huge wave of mergers and acquisitions among smaller banks because they need to get bigger,” said the co-president of one of the top six U.S. banks, who didn’t want to be named, when talking about the consolidation of the industry. “No other country in the world has as many banks as we do.”
How Did Any Bank Get Here?
To understand where the regional bank problem came from, it helps to think back to the chaos of 2008. This was caused by irresponsible lending, which fed a housing bubble whose collapse almost brought down the world economy.
After the first crisis, the biggest banks in the world were closely watched, and they needed bailouts to keep from going bankrupt. Because of this, the most changes were made to institutions with $250 billion or more in assets. These institutions had to go through annual stress tests and follow stricter rules about how much loss-absorbing capital they had to keep on their balance sheets.
On the other hand, banks that weren’t giants were seen as safer, so the government didn’t keep an eye on them as much. In the years after 2008, regional and small banks often traded for more than their larger counterparts, and banks that showed steady growth by serving rich homeowners or startup investors, like First Republic and SVB, were rewarded with rising stock prices. But even though they were simpler than the big banks, that didn’t mean they were less risky.
The sudden failure of SVB in March showed how quickly a bank could fall apart. This disproved one of the most important ideas in the banking business, which was that deposits were “sticky.” In the years after 2008, low interest rates and programs to buy bonds gave banks a cheap way to get money and made people feel safe enough to leave their money in accounts that paid almost nothing.
“For at least 15 years, banks have been awash in deposits, and with low rates, it has cost them nothing,” said Brian Graham, a banking veteran and co-founder of the advisory company Klaros Group. “That’s changed for sure.”
After 10 straight rate hikes and the fact that banks are back in the news this year, savers have moved their money to find better returns or a sense of safety. Now, too-big-to-fail banks are seen as the best places to keep money because the government backs them up. Big bank stocks have beaten regionals. The KBW Regional Banking Index is down more than 20% this year, while JPMorgan shares are up 7.6%.
That shows one of the things March’s chaos taught us. The Internet has made it easier to move money, and social media sites have led to a shared fear of lenders. Deposits that were once thought to be “sticky,” or hard to move, have all of a sudden become slippery. Because of this, it costs more to fund the industry, especially for smaller banks with a higher share of deposits that are not insured. But even the biggest banks have had to pay more to keep their reserves.
Some of these factors will be clear this month when regional banks report their results for the second quarter. Last month, banks like Zions and KeyCorp told investors that their interest income was lower than expected, and a Deutsche Bank expert named Matt O’Connor warned that regional banks may start cutting their dividend payments.
Friday, JPMorgan is the first bank to report earnings.
“The main problem with the regional banking system is that its business model is in trouble,” said Peter Orszag, who will be the next CEO of Lazard. “Some of these banks will be able to stay in business if they buy instead of being the target. Over time, we might see fewer but bigger regionals.”
The problem for the business is made worse by the fact that regulators are likely to keep a closer eye on banks, especially those with assets between $100 billion and $250 billion, like First Republic and SVB.
“There are going to be a lot more costs coming down the pike,” said Chris Wolfe, a Fitch banking expert who used to work at the Federal Reserve Bank of New York. This will lower returns and put pressure on earnings.
“Higher fixed costs mean you need a bigger business, whether you make steel or work in banking,” he said. “There are now more good reasons than ever for banks to grow.”
Wolfe said that competitors are likely to buy up half of the country’s banks in the next ten years.
A top investment banker who works with financial institutions said that while SVB and First Republic lost the most savings in March, other banks were hurt by the chaos. The banker said that most banks lost less than 10% of their deposits in the first quarter, but those that lost more may be in danger.
“You’ve got problems if you’re one of the banks that lost 10% to 20% of deposits,” a banker who didn’t want to be named said about possible clients. “You either have to go raise money and lose money on your balance sheet, or you have to sell yourself,” the person said.
A third choice is to just wait until the bonds that are underwater mature and fall off the banks’ balance sheets, or until interest rates fall and the losses get smaller.
But that could take years, and it puts banks at risk if something else goes wrong, like the number of office loans that aren’t paid back. That could put some banks in a dangerous spot where they don’t have enough money.
Another experienced financials banker and former Goldman Sachs partner says that banks are already trying to sell off assets and businesses to get more cash. This banker said that they are thinking about whether or not to sell payments, asset management, and fintech businesses.
The banker said, “A lot of them are looking at their balance sheet and asking, ‘What do I have that I can sell and get a good price for?'”
Orszag of Lazard says that banks are in a bind because the market isn’t open for new sales of lenders’ stock, even though their prices have dropped. He said that institutional buyers aren’t coming in because more rate hikes could cause the sector to fall again.
Orszag called the last few weeks a “false calm” that could be broken when banks report their results for the second quarter. He said that the industry still faces the chance that the negative feedback loop of falling stock prices and withdrawals of deposits could start up again.
Orszag said, “All it takes is for one or two banks to say, ‘Deposits are down another 20%,’ and all of a sudden, you’re back to the same situations.” “Hitting stock prices, which causes investors to pull their money out of the market, which in turn hits stock prices again.”
There Are Deals Coming Up
Several bankers said it could take a year or longer for deals to pick up speed. This is because people who bought out competitors with underwater bonds would take hits to their own wealth. After several failed deals in the past few years, executives are also waiting for authorities to give them the “all clear” on consolidation.
Janet Yellen, the secretary of the Treasury, has said that she is open to bank mergers. However, recent comments from the Justice Department suggest that deals will be looked at more closely because of antitrust concerns, and powerful lawmakers like Sen. Elizabeth Warren are against more bank mergers.
When the stalemate is broken, banks will probably try to maximize their size in the new system by grouping deals into several groups.
Banks that used to do well because they had less than $250 billion in assets may find that those benefits are gone. This could lead to more deals between midsized lenders. Klaros co-founder Graham says that other deals will build bigger companies with less than $100 billion or $10 billion in assets. These are likely regulatory limits.
Bigger banks have more resources to keep up with new regulations and customers’ requests for technology. This has helped financial giants like JPMorgan steadily grow their profits, even though they have to put up more capital. Still, buyers aren’t likely to be happy with the process.
But when one bank is in trouble, it opens the door for another. CFO Jason Darby says that Amalgamated Bank, which is based in New York and has $7.8 billion in assets, will think about making deals once its stock price goes back up.
“Once we feel like our currency is back to where it should be, we’ll look at our ability to roll up,” Darby said. “As time goes on, I think more and more banks will raise their hands and say, ‘We’re looking for strategic partners.'”