Stock market investors had to deal with an unexpected problem late last week, as quick and largely unforeseen bank failures echoed the systemic challenges that resulted in the financial crisis in 2008 and 2009. Major market benchmarks fell sharply, and bank stocks in particular plunged on uncertainty about which financial institutions might be the next to buckle.

Stock index futures initially rose Monday morning on news that the federal government would step in to ensure that depositors in key regional banks SVB Financial and Signature Bank, which both recently closed, got payment in full. However, as the open of regular trading approached, those gains turned into losses, and in the case of the Dow Jones Industrial Average (^DJI 0.04%), it resulted in a 1% decline. Those moves reflect confusion among shareholders in financial institutions about what the potential impact will be across the sector.

Old style building with word bank engraved in stone archway.

Image source: Getty Images.

Bank stocks prepare for the worst

Premarket trading revealed that many investors are concerned that there will be further dominos to drop before the short-term challenges in the banking sector are over. As of 8:30 a.m. ET, shares of Republic Bank (FRCB) and Western Alliance Bancorporation (WAL -1.14%) were trading down more than 60%. PacWest Bancorp (PACW) shares were lower by 40%, and several other financial institutions saw their stocks fall double-digit percentages.

The concerns even migrated to other corners of the financial sector beyond regional banking. Charles Schwab (SCHW 0.88%) shares were down another 7%, extending the brokerage stock's 12% decline on Friday. Even some major banks saw sizable declines, with Bank of America (BAC -1.25%) and U.S. Bancorp (USB 1.07%) both down 4%.

One factor in the declines has been that the federal government hasn't hesitated to step in when it has believed that shutting down a bank is in the best interests of depositors and the financial system as a whole. With earlier negotiations to find a buyer for SVB Financial having reportedly proven fruitless, government officials have made it clear that in protecting depositors, taxpayers will bear none of the cost.

That has two clear ramifications for shareholders in bank stocks generally. First, if an institution is struggling under the weight of unrealized losses on investment securities because of the dramatic rise in interest rates over the past year, as was the case with SVB and Signature, then shareholders need to be prepared to take a potentially total loss. Moreover, even those banks that do survive could see unanticipated losses when the Federal Deposit Insurance Corporation makes special assessments to shore up its own capital reserves in response to making payouts to depositors in banks that get shut down.

Wall Street looks confused

Even professional investors don't seem certain how to handle the situation. Several analysts downgraded shares of First Republic, expressing fears about what the immediate future could bring for regional banks. Other analysts, however, saw the situation more favorably, with J.P. Morgan characterizing the sell-off in First Republic shares as a dramatic overreaction. Some even suggested now was a great time to buy regional bank stocks.

Going forward, the health of the banking sector could rely on the Fed. The central bank created a new program that will allow banks to take out loans using Treasury securities and other high-quality assets as collateral. That could help financial institutions bridge the gap without having to liquidate their holdings at a substantial loss.

Longer-term, banks are going to have to come to terms with the fact that the era of rock-bottom interest rates might be over for good. Instead, they'll have to pay higher rates on deposits -- or else potentially face depositors pulling their money in favor of better income-producing options elsewhere.