After the collapse of SVB Financial's Silicon Valley Bank and Signature Bank, and the forced acquisition of Credit Suisse, the regional banking sector has struggled.
I believe most regional banks will survive this crisis and that the selling probably is overdone. Many regional banks have done a much better job of protecting their balance sheets from interest rate risk and have a much more diverse deposit base.
But regional banks are still facing a much tougher outlook than they were before the collapse of SVB because of headwinds that probably will pose rising challenges to the industry.
Earnings struggles
Unfortunately, most banks are going to face earnings struggles at least this year and maybe in the years to come. Given concerns about liquidity and deposit outflows, I suspect most banks are going to hold a larger cash position than they probably would have, at least until conditions stabilize. Holding cash hurts bank margins because banks make money by using deposits to buy securities or make loans, so if more deposits are sitting idle then profits will be lower.
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Additionally, banks are going to have to avoid falling into the same trap as SVB. The bank invested in longer-maturity government-backed bonds that lost value as interest rates rose. The unrealized losses sitting in SVB's bond portfolio ended up being so large that they wiped out all of the bank's tangible common equity, leaving the bank with no backstop when it experienced a deposit run.
Banks are also likely going to have to manage their bond portfolios much more conservatively, which makes sense right now anyway. I am sure regulators are going to be laser-focused on bank bond portfolios and there will be a greater tendency for banks to hold cash and invest in shorter-duration bonds, which in a more normal environment yield less than longer-maturity bonds.
Finally, I think regional banks are going to see some pressure on their deposit bases, which they were going to see this year anyway. I suspect many will have to pay up more for deposits and see more outflows than they would have, which ultimately hurts their margins.
More regulation
Regulators and lawmakers are certainly going to discuss whether there needs to be tighter regulation so a crisis like this -- once it's over -- doesn't happen again.
The first thing that will most likely happen is that lawmakers will raise the amount of deposits the Federal Deposit Insurance Corp. (FDIC) insures. The current limit is $250,000 per depositor and banks with a large amount of uninsured deposits saw deposit runs as customers worried about what might happen if their bank fails and they had more than $250,000 in the bank.
I think most would agree that the $250,000 cap should be raised and this move will likely help boost confidence. But FDIC insurance is covered by the banks themselves, through annual FDIC assessment fees. If more money is needed to finance the FDIC's insurance fund, regional banks will incur higher expenses on this front.
Once the dust settles, I also expect regulators and lawmakers to look at and pass stricter regulations when it comes to liquidity and maybe even higher capital requirements as well. While capital really wasn't the core issue in this crisis it's always an ongoing debate about how much capital banks should have to hold. I would expect it to be part of the discussion again, particularly around how much capital banks have to hold against bonds. The more regulatory capital banks must hold the lower their returns. There will also likely be more components when it comes to stress testing and regional banks may get stress tested more, which is already a burdensome activity.
Lower returns and higher cost of capital
I do think a lot of regional banks that managed their balance sheets prudently and have strong deposit bases have been indiscriminately sold off amid the turmoil and I do see opportunities right now.
But all regional banks now face struggles. For one, their earnings are likely going to be challenged, especially in the near term, and they are going to have to fight harder to win deposits and relationships from the megabanks. Regional banks have taken a reputational blow and many businesses and consumers are going to view banks such as JPMorgan Chase and Bank of America as safe havens. Banks are also likely to see higher FDIC assessment fees and regulatory requirements for liquidity and capital that could very well crimp longer-term returns.
This is all going to happen as regional banks face a higher cost of capital, meaning they are going to need to generate higher returns to get investors interested because the sector will be viewed as riskier for some time.
