More Bank Failures

After the bank failures of 2023, the chairman of the Federal Reserve Jerome Power said: “This is a problem that we'll be working on for years more, I'm sure. There will be bank failures, but not the big banks.”“You could see some banks either fail or at least dip below their minimum capital requirements,” said Christopher Wolfe, managing director and head of North American banks at Fitch Ratings.

Consulting firm Klaros Group analyzed about 4,000 U.S. banks and found 282 banks face the dual threat of commercial real estate loans and potential losses tied to higher interest rates.

The majority of those banks are smaller lenders with less than $10 billion in assets.

“Most of these banks aren’t insolvent or even close to insolvent. They’re just stressed,” Brian Graham, co-founder and partner at Klaros Group, said. “That means there’ll be fewer bank failures. But it doesn’t mean that communities and customers don’t get hurt by that stress.

Hundreds of mid and small banks are at risk. More than 280 are at risk from commercial loans.

How Much Money is at Risk

Some $900 billion at risk.

Stress results from inadequate capital, excess commercial loans, and high interests loans on the books, especially when rates are falling, leaving the bank in a margin squeeze.

How does bank stress affect consumers?

The results of small bank failure is more indirect. Not all such banks are on the verge of failure. Stressed banks could simply forgo investing in the next technological tool, innovation, enlarging, remodeling or hiring more staff.  So customers don’t always see the stress even though it is there.

There is one big safety mechanism

If your bank is FDIC-insured, the FDIC will return your insured deposits within two business days. The FDIC insures up to $250,000 per depositor, per FDIC bank, and per ownership category.

Chairman Powell says,  “there are going to be bank failures.”  So he asks bank managers, “are you being truthful with yourself and owners?”

When banks have to pay more for their money, there profit goes down. These high interest rate margins remain on the balance sheets. Typically, the bank borrows at 3% and lends at 6%.  It can make money that way. But when rates rise and banks pay more to borrow money, that model becomes inverted. And banks lose money.

Good bank managers know how to work with this dynamic. For example, they restructure loans, lower interest rates or raise capital.

The borrower can refinance the loan by getting a loan with lower interest rates and a lower payment.  This also takes the bank off the hook with its higher than normal interest rate.

A bond with a callable feature can be redeemed early by the issuer in times of decreasing interest rates.  This allows the issuer to restructure debt in the future because the existing debt can be replaced with new debt at a lower interest rate.

In order for bank managers to pivot in this surefooted way, they must be knowledgeable, nimble and alert.

Some experts believe that stressed banks can be resolved in the private sector, not asking for government bailouts.    Undercapitalized banks are stressed. Stronger banks can acquire smaller banks. In extreme cases, the federal government has mandated such acquisitions. This could be required when larger banks are reluctant to take on the risks of a stressed bank.

Paul Taylor of Fitch Ratings says in such cases mergers undergo closer scrutiny. Chairman Powell says many of these situations are manageable.  Some institutions may need to be cajoled to raise capital.  Clearly, there are some failures on the horizon, but we will not see a massive wave of bank failures, Powell says.

Powell’s goal is clear: reduce the number of failures this time around in 2025 and 2026.

Stressed banks are not insolvent or even close to insolvency. And if small banks do fail, the economy will be just fine.

Reverse Stress Testing

Michael Barr, second vice chair of the Federal Reserve Bank, says that reverse stress testing can help prevent bank failures and make banks more resilient. Ask, what would it take to break this bank? Thus we can avoid being  caught off guard with just two days to act. Bank managers can look inward and see red flags and act promptly.   

What counts as capital has changed over the years. For example, now banks use checking or savings accounts, investments in stocks, bonds, mutual funds, certificates of deposit, money market funds, and trust accounts. This has somewhat skewed the system. It used to be good hard cash.

Current reserves minimum are 5%.  Some bank regulators want reserves to be 10%. Others say 30% would be truly safe.

Safety vs Growth

The goal is to strike a delicate balance between safety and growth. The higher the risk the greater the profit for the bank; the lower the risk, the lower the profit. This is where smart management comes in.

Smart Management

Alert managers look at all the variables and strike a balance between safety and growth. Innovation, risk, capital and safety work together. Good managers take the initiative when it’s time; for example, to raise capital or time to merge.

Rate increases mean that banks also pay higher interest rates for money, reducing their profits and  stressing the banks. A record $900 billion in such loans are coming due soon. That’s a lot of stress.

The Fed is making under the radar calls for these stressed banks to raise capital. However, bank acquisitions have swindled in recent years. Many banks are still struggling since failures in 2023.

Confidence is everything. But behind the public facade of confidence and discretion there must also be decisive and prudent action, is the clear inference we’re hearing.

There are about 4600 banks in the US. About 4,000 banks are small or community banks.  But the 4,000 banks handle as much money as do the largest bank in the US: JP Morgan with $3.2 trillion in assets.

Community banks hold between $1 and $10 billion each in assets. Mid-sized banks hold from $10 billion to $100 billion in assets. The Kiara’s Group analyzed 4,000 banks. It red flags banks with over 300% capital in commercial real estate loans and potential losses tied to higher interest rates.

The Breakdown

Some 282 banks are at risk. And 16 of these are larger banks. Why is getting this right so important? Because failures would hamstring their communities.