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The days of easy financing and rock-bottom interest rates are over—and small and regional banks will have to batten down the hatches in the coming months to avoid sharing the fate of Silicon Valley Bank and First Republic Bank.  

While regional bank stocks have rallied from their historic tumble this spring, small and midsized banks are still struggling to right themselves in the face of investor scrutiny. Moody’s recently downgraded the credit rating of 10 regional banks and warned of potential rating cuts for 17 others. And those investing in regional banks are demanding higher returns for their vote of confidence.

Financial institutions can no longer assume these high-profile bank collapses were the exception to an otherwise resilient market. To navigate these challenges—along with the ongoing risk of recession, a creaking commercial real estate market and high interest rates—they’ll have to act now.

In what follows, we’ll cover the challenges banks can expect in the coming months—and how they can revamp their stress testing and shore up their portfolios to help mitigate future risk.

How We Got Here—and What’s in Store

The Great Recession reshaped the banking landscape as regulators slashed interest rates and enacted legal reforms aimed at bolstering the U.S. financial system. But while the Dodd-Frank Wall Street Reform and Consumer Protection Act tightened stress testing requirements for nation’s biggest banks, it largely left small and regional banks out of regulators’ crosshairs. Many of these banks only reported stress tests every other year; some didn’t at all. Subsequent amendmentswidened those accountability gaps.

Fast forward to 2022, when the Federal Reserve took strong action to curb stubborn inflation, catching small and regional banks off-guard. Banks had benefitted from an extended period of low interest rates, which created an expectation that they would persist indefinitely. Because of that, many had taken on riskier portfolios and ignored protective hedging against rising interest rates.

This devastating confluence of factors—a lack of oversight, poor liability management and stormy market conditions—helped spark the third largest bank run in U.S. history. In SVB’s case, the bank held too many long-term treasury bonds, which couldn’t be quickly sold without a loss after the rise in interest rates.

Exacerbating this complex set of issues: the sheer number of banks holding a substantial level of commercial real estate (CRE) loans as part of their portfolios. By mid-2022, more than 500 U.S. banks exceeded the CRE loan concentration guidance laid out by federal banking agencies in 2006. 

As millions of CRE leases expire over the next two years, real estate values could plummet if businesses capitalize on the shift to remote work by shrinking their footprint in downtown offices. If the market value of those properties sinks below the principal owed on their mortgages – an outcome more likely given today’s high interest rates – it could again produce another “break-the-bank” scenario and a significant economic downturn.

How Banks Can Mitigate Risk in the Event of a Downturn

To navigate these headwinds, banks have a wide array of tools at their disposal. Here’s what they can do to strengthen their position should the banking sector face further economic turmoil:

• Shore up deposit insurance coverage: Some banks are turning to other organizations to secure deposit insurance beyond the $250,000 the Federal Deposit Insurance Corporation (FDIC) provides for each depositor. SoFi, for example, provides the capability to spread liability risk across several banks. Capitalizing on these services would allow banks to take individual deposits as high as $2 million, enabling them to return large deposits quickly in a challenging market.
• Leverage managerial tools: Whether it’s a matter of lax leadership, or the fact that stress testing is simply not required for some smaller banks, senior management can sometimes ignore the fundamentals of stress testing. They should ensure they’re taking advantage of every tool at their disposal. Certain models and software, for instance, can streamline the analysis of balance sheet components, and facilitate liquidity management, asset liability management and loan risk management.
• Assess loan portfolios against CRE market trends: As of now, CRE loans are the most vulnerable components of banks’ balance sheets. Organizations with substantial capital in this area will have to hedge against the possibility that, while first-tier CRE properties may get leased out at higher interest rates, investors may feel struggle to refinance CRE loans for second-tier office buildings.  If tighter loan requirements spur an uptick in defaults, banks must prepare to absorb substantial losses.
• Hedge against the consumer loan market: The consumer lending market has held up remarkably well against economic volatility, buoyed by low unemployment rates and steady consumer spending. But the resumption of student loan payments could change that calculus. Because federal loans cannot be discharged, there may be knock-on effects that slow discretionary spending across the middle class. Defaults on private student loans could also negatively impact banks’ portfolios, as they are typically securitized and sold to a wide range of banks.
• Preparing to diversify: Zooming out, this usually involves the board taking steps to diversify the bank’s loan portfolio. For regional banks, that exposure is often tied to their borrowers’ geographies. For instance, CRE loans for Class B offices in central business districts are likely riskier than those in surrounding neighborhoods.
• Getting an outside perspective: Small and regional banks often lack the in-house expertise to deploy detailed assessments and conduct complex stress testing. Leveraging a third-party organization can yield impressive results for banks without the internal resources to perform those services themselves. Such partner organizations also bring deep experience from decades working alongside a broad array of banks, and have national resources dedicated to tackling these challenges.

Better Stress Testing Can Provide a Blueprint for Limiting Risk 

To survive a nightmare scenario, banks should incorporate several different potential outcomes into their stress testing. Specifically, they should model and map out how future interest rate hikes would impact loan refinancing and property valuations. Timing is also critical. If a bank has over 50% of its CRE loans maturing in the next 12-18 months, it should model what the real estate market might look like during that timeframe.

If the outcome of a bank’s stress test is catastrophic, this is an opportunity for the bank to take preemptive action before its competitors do the same. They can start by:

Banks should also develop a policy around reappraisals. Vacant properties will require banks to obtain appraisals for new mortgage loans. Should office vacancy rates rise precipitously, banks will need to brace for lower valuations across the board.

The Time to Prepare is Now

A bank collapse can happen in a matter of days once word of potential financial instability gets out. Even a fundamentally sound organization can fail if it can’t meet depositors’ demands for funds.

That’s why it’s critical for banks to assess their exposure now and plan accordingly. By conducting internal stress tests with a trusted partner, banks can identify key areas of exposure and head them off before it’s too late.

If you have any questions, please do not hesitate to connect with us.

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