Global equity markets have trended higher in recent weeks, with performance in regions outside the U.S. being notably stronger. Investors have been focused on the employment picture and recent comments from the Bank of Canada and the U.S. Federal Reserve. Both institutions have reiterated the need for patience, awaiting further evidence that inflationary pressures are contained. Below, we revisit the stresses that emerged in the U.S. regional banking sector about a year ago and address similar concerns that have resurfaced.
About a year ago, three U.S. regional banks were caught in a precarious position, which resulted in a significant exodus of deposits and the banks’ subsequent failure. This vulnerability stemmed from a significant decline in the value of the long-term fixed income securities on their balance sheets, caused by rapid and extensive interest rate hikes by the U.S. Federal Reserve. The disclosure of a substantial loss on the sale of these securities as well as a capital raise by one of these banks led to concern among depositors, initiating a cascade of withdrawals. While these banks were forced to shut down, policy makers stepped in to guarantee all deposits and set up a new lending facility to support banks under pressure. These measures helped to restore confidence in the banking system and to stem deposit outflows.
In recent months, concerns have re-emerged in the U.S. regional bank sector, with investors focused on potential losses in commercial real estate loans. This loan category has been under scrutiny for the past year given the impact of higher interest rates and pandemic-induced shifts, which have resulted in higher vacancy rates in certain properties like retail and office buildings. These loans are disproportionately held by small to mid-sized U.S. banks.
A particular bank recently drew attention as it surpassed the $100 billion asset threshold, subjecting it to stricter capital requirements. It had high exposure to commercial real-estate, but specifically to areas experiencing increased stress, such as rent-controlled multifamily units and office buildings in New York City. The bank disclosed material weaknesses in its loan risk assessment process, announced a provision for loan losses that was nearly ten times the expected amount, cut its dividend, replaced a number of senior executives, and was downgraded by credit rating agencies. Over the past week, it received a significant capital injection from several institutional investors, aiming to stabilize the company.
While this bank’s situation is unique, its difficulties have stirred up broader worries about commercial real estate and have prompted a reevaluation of risks among small to mid-sized U.S. banks. Overall, we believe the commercial real estate risks are generally well-understood by the markets, and many banks, particularly larger ones, have provisioned appropriately in preparation for any potential losses.
Importantly, the emergency lending facility and deposit guarantees which formed the backbone of the policy support last year should continue to give depositors confidence in the near-term. Even so, we will not be surprised to see some other regional banks show potential signs of weakness in the future as the lagged effects of higher interest rates continue to work their way through the economy. We take comfort from the credit and interbank lending markets which continue to behave well, indicating minimal broader financial market implications at this point.
Should you have any questions, please feel free to reach out.
David Blair
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