Small, mid-sized, and regional banks are critical to the health and functioning of the U.S. economy. However, the failure of three regional banks in as many months (two of which rank in the top-three bank failures of all time) has raised questions about the safety and stability of this important part of the banking system.
The hyper-low-rate environment that followed the post-global financial crisis (GFC) gave super regional and other small-to-mid-sized banks expanded scope to increase lending activity and profitability in numerous sectors. By contrast, the fastest pace of monetary policy tightening in decades had a largely unanticipated effect on bank balance sheets, particularly on the ability of small and mid-sized banks to competitively fund themselves through deposits. In the higher-rate environment, deposits became steeply more expensive not only as cash sought higher yields available elsewhere, especially money market funds, but also because small and mid-sized banks experienced a safety taint following the failure of three high-profile banks. The latter caused deposits to migrate to the safety associated with global systemically important banks (GSIBs), or, more colloquially, the “too big to fail” larger banks. In light of the elevated costs of short-term funding and the steeply inverted yield curve—meaning that banks raising capital in short-maturity markets paid more than they received lending it out in longer-maturity securities—the earnings power of these small and mid-sized banks has been temporarily impaired.
In addition to these challenges on the liability side of small and mid-sized bank balance sheets, the asset-side has also seen difficulties. Specifically, longer-maturity assets such as Treasury bonds experienced significant declines in value due to the unexpected and rapid increase in interest rates. So just as cash started to flow out of these banks—to the extent their assets were invested in unhedged, longer-dated bonds and loans—those assets declined in value, leaving less capital available to fund the deposit withdrawals. This constitutes an asset-liability mismatch and, as mentioned, has thus far proven fatal to three institutions.
Today, the Fed’s process of raising the federal funds rates is likely behind us either in large part or in totality. The pressures that banks faced in recent months are unlikely to repeat. Not only is the Fed likely done raising rates, in our view, economic weakness in the second half of the year could bring with it a decline in rates that would further alleviate the asset-liability mismatch issues for bank balance sheets (though credit quality could suffer). What’s more, going forward, as is common with these types of events, bank management and regulators are likely to be far more attuned to this particular risk, unlikely to repeat the same mistake anytime soon.
The remainder of this piece focuses on what higher cost of funding for super regional, small- and mid-sized banks means for the industry and the economy. We also discuss the prospects for increased regulation and how that may slow lending, further compromising the bottom line of these banks. All of this results in a near-term environment where small and mid-sized banks may struggle to compete with large money-center banks, and their reduced activity could weigh on the overall economy.
The post-GFC advantage to small banks
There are several ways of defining banks by size. We choose to break the banking landscape into three categories: First, there are money center banks, which include the four largest by total assets, designated by regulators as GSIBs. Second, are banks with assets above $100 billion, defined as super regionals. These banks follow a regional or community bank model but have significantly more scale than the third category: small- and mid-sized banks. In our analysis, this last group includes banks with less than $100 billion in assets, typically operating across a smaller regional footprint and with a more localized community bank model (Figure 1). Notably, those in the third category are subject to a less rigorous regulatory regime, including that they are not subject to periodic capital adequacy stress testing by regulators.
Figure 1: Lay of the banking land
Categories of banks by business model, market capitalization, and total assets