A pause from the Fed is certainly welcome from a broader macro perspective, but the challenges facing local and regional banks in particular, are still prevalent.
The three bank failures so far this year pale in comparison to the dozens of bank failures every year from 2008 to 2013; however, by asset size, 2023 is by far the costliest. While the Federal Reserve (Fed) has hinted that it may be finished raising interest rates, investors are rightfully concerned if there could be more bank failures on the horizon and how stress in the banking sector could impact the broader economy.
A pause from the Fed is certainly welcome from a broader macro perspective, but the challenges facing local and regional banks in particular, are still prevalent:
- Consumers have been withdrawing deposits from their traditional bank checking and savings accounts in favor of higher yielding, liquid products like money market funds. While deposit outflows from small banks have stabilized somewhat in recent weeks, the broad pressure on deposits is unlikely to change until the Fed starts cutting rates.
- Small banks’ primary business model is to issue loans to businesses and consumers. Given the outlook for a slowing economy, demand for loans is set to come under pressure therefore impacting profitability.
- During the pandemic, banks purchased fixed income securities at low interest rates. When rates moved higher as the Fed tightened, banks had to sell those securities at a markdown to meet deposit outflows. Some banks still hold these assets with sizable unrealized losses.
- Small banks are heavily exposed to commercial real estate, accounting for ~70% of loans outstanding. Given the stresses in that market, particularly in office, this could be worrying as some of those assets are marked down.
Overall, these issues have led to significant tightening in lending standards. Moreover, the impact on the economy may soon be visible in the labor market. Notably, roughly 52% of the private workforce is employed by companies with 500 or fewer workers1. Many businesses of this size bank at local and regional financial institutions. As reported by small businesses, the availability of loans has become more restrictive and securing a loan has become more costly. Indeed, the average interest rate paid on short term business loans has more than doubled from 4.1% in mid-2020 to 8.5% today2.
Assuming small businesses have, on average, 3-6 months of operating cash to cover expenses, when businesses look to access credit for their business needs, it’s likely they’ll be met with a painful reality of having to lay off staff to keep their doors open. As highlighted, tighter credit conditions tend to lead weakness in labor markets. For investors, the challenges in the banking sector have likely gone from an acute pain to a slow burn that could begin to impact small business employees. As such, a more defensive, high-quality posture within portfolios seems appropriate.