The circumstances affecting each institution may have been idiosyncratic, but they all ultimately suffered from rapidly fraying investor confidence and a liquidity problem. Central banks in the US and Europe acted relatively quickly to limit potential bank run contagion, but investors and the banking sector at large remain unsettled.
In the US, investors are still concerned about further bank runs, even after the news that JP Morgan has agreed to take over First Republic Bank – the third US bank to fall in recent months. In Europe, the unexpected write off of USD 17bn in AT1 bonds was a blow to investor trust and has created an uncertain outlook for those instruments.
In both regions, there are concerns about the performance of certain commercial real estate loans, and everyone is wondering whether central banks and regulatory bodies will announce new measures in response.
What happened at a glance
- Silvergate: regulatory challenges and the collapse of crypto exchange FTX triggered a run on the bank. It ceased its operations on March 8.
- SVB: mounting pressures including Treasury investments losing value and VC/ tech depositors withdrawing large amounts of money led to California’s regulators stepping in on March 10.
- Signature Bank: shortly after SVB’s collapse, Signature Bank suffered a similar fate. Deposits started quickly leaving the bank and it was closed down by regulators on March 12.
- First Republic Bank: on March 16, First Republic received a USD 30bn rescue package from 11 US banks to prevent its collapse.
- Credit Suisse: problems had been brewing for years and investors started losing confidence quickly, resulting in a rapidly intensifying liquidity crisis and takeover by rival UBS on March 19.
- First Republic Bank: the USD 30bn rescue package proved futile and on April 30 the bank collapsed, with JP Morgan agreeing to take it over.
Third Bridge has interviewed dozens of industry experts in the US and Europe in recent months for their perspectives on the events that unfolded and what they are now worried about.
US regional banks: “most people in the market did not see this coming”
One of the most troubling factors about the closures of Silvergate, SVB and Signature Bank was that “most people in the market did not see this coming”, a former director at Pacific Western Bank said. Investors have since been on high alert for signs of other banks getting into difficulty. “Everybody is looking across their way and saying, ‘Who’s next? Who’s the next Silicon Valley Bank, and what’s the Fed going to do?’,” a former banker at Western Alliance Bancorp told us. First Republic Bank collapsed over a month after those Forum Interviews took place, with depositors protected but shareholders wiped out.1https://www.ft.com/content/0c61a540-e6be-4bca-8054-841d9983756b
As we know, SVB was the first domino to fall. When news of SVB’s troubles first surfaced, investors grew concerned about bank liquidity and a bank run ensued. Signature Bank was not far behind. There were record US banking deposit outflows in March 2023 and Q1 results highlighted the tide of deposits into “too-big-to-fail” institutions and higher- yielding money market funds. For example, JP Morgan reported a 2% QoQ rise in deposits and Citigroup’s CFO said the bank saw a “meaningful” inflow related to the turmoil.2https://www.reuters.com/business/finance/jpmorgan-amasses-deposits-customers-move-money-largest-us-bank-2023-04-14/#:~:text=JPMorgan%20reported%20a%202%25%20rise,inflow%22%20related%20to%20the%20turmoil
The US regional banking Q1 2023 picture revealed mixed results overall, reflecting deposit outflows for many lenders despite persistent net interest income growth on the heels of interest rate increases. Although deposit outflows have largely normalised, profit margins remain under pressure as heightened competition forces banks to increase their savings rates while also earning less on loans.3https://www.ft.com/content/debb3365-c8f8-48d3-b759-59c06960b475 An executive at a commercial lending specialist told us that this, plus a pullback on lending, could result in net interest margin compression across regional banks of 25-50bps.
Commercial real estate fears mount
What investors are watching closely for now are unrealised losses on commercial real estate loans as fears of delinquencies rise. The former Western Alliance banker said regional banks’ commercial real estate portfolios could take substantial hits on loan-to-value – particularly in the Southeast and West Coast – for up to 24 months due to the tougher lending environment. “You’re going to see some real estate that’s going to, I’m not saying it’s going to be 2008, but it’s going to be very similar to that where you’re going to see foreclosures go up, you’re going to see collections go up, you’re going to see defaults go up.”
“You’re going to see some real estate that’s going to, I’m not saying it’s going to be 2008, but it’s going to be very similar to that where you’re going to see foreclosures go up, you’re going to see collections go up, you’re going to see defaults go up.” Former Western Alliance banker
As has been widely reported, a downturn in US commercial real estate valuations, particularly office space and non-prime retail buildings, could lead to write-downs and wider financial industry challenges. Despite heightened concerns for borrowers as banks pare back lending, Signature Bank’s closure demonstrates that it is critical to manage risk “even if it means a contraction of [sector-wide] credit”, a former executive at the Office of the Comptroller of the Currency (OCC) said.
Regulatory pressures are clear
The banking failures and the decision to protect uninsured depositors “raised fundamental questions” about the role of deposit insurance in the US banking system. Last week, the Federal Deposit Insurance Corporation (FDIC) proposed extending the USD 250,000 insurance limit for business accounts – the first major regulatory proposal on banking in the aftermath of these events. The FDIC offered three options for the federal deposit insurance system: maintaining the current framework, extending coverage for all depositors, or increasing the backstop for business accounts. It concluded the latter option “best meets the objectives” of financial stability and depositor protection relative to cost. Eliminating the cap would be expensive and might undermine financial stability, with banks tempted to take greater risks, the FDIC said.
There have also been calls for regulators to strengthen banking rules. However, a Professor Emeritus at City University of London we spoke to believes the regulatory landscape has become too complex, noting that because banks invest in the same way and by the same rules, they are exposed to common shocks. The expert is of the view that there is too much emphasis on specific risks instead of building a resilient financial system. “One of the problems with regulation is that it tends to encourage banks to do what is called best practice, but best practice is difficult to define.”
“The regulator telling them what to do does tend to make the banks behave the same way, and that’s a mistake.” Professor Emeritus at City University of London
We were also told that the challenges faced by SVB and other regional players have highlighted a “systemic problem” related to asset-liability duration gap challenges. “They’re… illustrating a general phenomenon that affects about 200 banks… until there’s action… you’re going to have this continuing problem,” the former OCC executive said. Before the collapse of SVB, a former VP at the bank told Forum that SVB “very much mismanaged their balance sheet in terms of some of the treasury portfolio”, noting that this contributed to net interest margin compression in the preceding quarters.
Will there be consolidation?
We have heard during our Forum Interviews that market conditions could provide fertile ground for M&A across the US regional banking space, with a former executive at SVB predicting there could be 10-15% consolidation. It has also been reported that new regulations may prompt more M&A activity. JP Morgan’s CEO, Jamie Dimon, reportedly told a conference that “banks will consolidate” in response to recent events. Large regional banks could merge with their peers to better compete with banking giants, while small and mid-size lenders could be subject to take over as customers flee to larger institutions.4https://www.reuters.com/markets/deals/jpmorgans-takeover-first-republic-fuels-ma-expectations-2023-05-01/ PacWest said it has been approached by “several potential partners and investors”, with discussions ongoing.
“There’s going to be some consolidation, the question is, is it going to be massive or not? […] I would not be surprised to see something in the 10-15% range.” Former executive at SVB
Although pressure on US regional banks has eased for now, with deposit outflows stabilising and in some cases reversing, the sector is not out of the woods.5https://www.ft.com/content/2101d5b6-d4dc-404a-93c5-d2b1af8df0e5 The next few quarters are expected to be choppy as banks grapple with inflation and interest rates, an evolving regulatory landscape, and renewed focus on financial stability. Institutions are expected to earn less on their loans and pay more for their deposits, while tighter banking regulations could also require them to raise more capital.
On First Horizon Bank’s terminated merger with Canada’s TD Bank, a former executive at the bank told us that persistent uncertainty over US regional banking developments was likely to have played a significant role in the decision.
Europe: distinct circumstances but similar destiny
What happened to Credit Suisse was driven by a unique series of events stretching back over a number of years. However, just as we have seen in US regional banks, one trigger brought about a widespread crisis of confidence and, ultimately, a rapid demise.
Many investors are still reeling from the USD 17bn of AT1 debt marked as worthless as part of the rescue merger with UBS. The Swiss regulator’s actions ushered a global selloff in AT1 bonds – and even though prices rebounded, investors remain concerned about the long-term ramifications of the write-off. Investors representing over USD 5bn of Credit Suisse bonds are now reportedly seeking to sue FINMA.6https://www.reuters.com/business/finance/credit-suisse-bondholders-sue-swiss-regulator-over-17-bln-bond-wipeout-ft-2023-04-21/
“This event… let’s not see it in isolation. It’s to be seen in conjunction with Signature Bank, SVB, etc. This will make investors more cautious… it will make banks and the shadow banking community more cautious about lending.” Former Credit Suisse executive
AT1 investors have been reminded of what could be at stake if a bank gets into difficulty. As banks typically reward AT1 bondholders with a higher yield, we have heard they will likely have to pay more on new bond issuances following the Credit Suisse rescue. A former UBS director said bank funding costs are also likely to increase due to rate rises and widening credit spreads. In response, Interviews suggest banks may start to grow retail funding channels.
Could commercial real estate be the “final straw”?
Financial market instability has been visible across the board but particularly so in private markets, where “we’ve certainly seen impact in terms of pricing and liquidity”, an executive at NatWest Markets said. As we have heard, an already struggling EUR 1.5trn commercial real estate (CRE) loan market has come under more pressure as higher interest rates have increased borrowing costs while valuations remain depressed.
Commercial mortgage-backed securities (CMBS) represent a small part of European CRE but it “may well be that the area of the bank that it sits within is a material enough part that it could be the final straw” for some, the NatWest Markets executive added. Experts we have spoken to have noted that non-performing debt could cause liquidity crises given some banks’ large exposure to real estate.
The “CMBS market by itself won’t bring down the European banks, but it is one piece of the evolving European CRE story”, the specialist added. They said the banking turmoil has added to existing sector headwinds, including the impact of the Russia-Ukraine conflict, inflation and rate hikes. “All of these pieces are putting you in a position where, on individual transactions, maybe it’s looking a bit questionable. There are going to be some challenges, some real, serious challenges in terms of refinancing.”
Investors in both Europe and the US are keeping a close eye on the CRE market and banks’ exposure to those assets, with our expert noting that with commercial mortgagebacked securities there is a “real bifurcation” between the two regions. Here, they said they are more confident about Europe’s outlook given the relatively small size and structure of the market.
“What you will see in the bank sector is what you saw, for example, with Silicon Valley Bank, or other banks, they will have a problem if not only the asset side is problematic because it’s low yielding, but, number two, if it’s combined with the loss of the cheap funding base.” Executive at real estate company
In an Interview on European real estate, our expert said they do not expect a large volume of non-performing loans, but outlined a scenario in which challenges may arise. “What you will see in the bank sector is what you saw, for example, with Silicon Valley Bank, or other banks, they will have a problem if not only the asset side is problematic because it’s low yielding, but, number two, if it’s combined with the loss of the cheap funding base.”
Meanwhile, we heard direct lenders are “eating the lunch of banks” that are pulling back on CRE lending. With new business representing 20% of the market, debt funds are positioning themselves to take on more business than they had previously. “I definitely see this as a trend, that direct lender funds or alternative structures are now more in the game,” the real estate company executive said.
What do recent banking events in the US and Europe mean for the future?
The Credit Suisse rescue in Europe and regional banking turmoil in the US have tested the system’s financial resilience, with global regulators reportedly considering tougher rules on some lenders.7https://www.ft.com/content/eda3dc55-b350-483d-a52f-e509b4256b6f Experts have emphasised that Europe appears more stable vs the US, as strict regulations are already in place.
A former Credit Suisse executive said there could be a reassessment of how banks are stress tested, noting that recent events suggest such tests were designed for “an environment that is calmer in terms of customer and shareholder confidence”. Businesses were also set up for a world of low rates, but the plateau is now much higher. “It’s changing how people save, it’s changing how they invest, and it’s putting stress on institutions,” the specialist said. Depositors also now move much faster than they did in 2008.
“The saying in financial markets is that crises happen slowly and gradually… more slowly than you might expect, then they accelerate dramatically and happen at lightning speed.” Former executive at Credit Suisse
As we have heard from industry experts, investors and lender confidence alike is expected to be more fragile in the wake of recent banking turmoil. What has been evident in both the US and Europe is how quickly investor confidence can crumble and how a single trigger can create a concentrated perception of risk – particularly in the digital age where social media can rapidly transmit fear and panic.
The information used in compiling this document has been obtained by Third Bridge from experts participating in Forum Interviews. Third Bridge does not warrant the accuracy of the information and has not independently verified it. It should not be regarded as a trade recommendation or form the basis of any investment decision.
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