Key Questions: Are Renewed Banking Fears Something to Fear?

Background

Since the COVID pandemic, the banking sector has been battered by several forces. In particular, rapidly rising interest rates have created asset-liability mismatches and increased the cost of doing business at the same time that work-from-home trends have reduced demand for office leases, putting pressure on real estate loans held by some banks.

As a result, a year ago this month, several noteworthy banks collapsed. Bank sector credit spreads widened by approximately 100 basis points (1%) at the time but have modestly recovered since then. However, banking fears were renewed on January 31, 2024, when New York Community Bancorp (NYCB), a regional bank, unexpectedly reported a loss, materially cut their dividends, and posted higher-than-expected loan loss provisions due to stresses in its commercial real estate (CRE) portfolio. The event resulted in US bank stocks aggregately falling 4.5% and regional bank stocks falling 9.5%; credit spreads widened at least 10 basis points.

Canary in the Coal Mine?

Despite the market reaction, we do not believe NYCB is indicative of a larger, more worrisome trend. NYCB’s issues were largely idiosyncratic and related to becoming a Category IV bank ($100B+ assets) after the acquisition of some of Signature Bank’s assets and liabilities. Regarding the issues:

1. Unexpected Provisions for CRE — NYCB was under-reserved for CRE when compared to its new larger peers. Thus, posting higher provisions was essentially playing catch-up with Category IV peers. Too, CRE (particularly the office sector) will remain a headwind, but it is not an unforeseen risk.

2. Dividend Cut — The cut was driven by the need to quickly build capital in order to satisfy higher regulatory requirements associated with becoming a $100B+ bank.

Commercial Real Estate

As one of the primary reasons for NYCB’s reported loss, commercial real estate is understandably a renewed focus of investors. Specifically, office CRE poses a continued risk given work-from-home structural trends that have lessened demand. Looking across the sector’s loan books, we can see that regional banks make up the bulk of CRE lending. On average, these banks have roughly 3% of their loan portfolio exposed to office lending; money center banks have even more modest exposures. Despite the difference in the allocation of office exposures, it is also important to consider the composition of these exposures since some reside in geographical markets that are stronger than others. As such, overall risks from CRE exposures cannot be assessed solely based on percentage amount and require deeper analysis.

Regional Banks Health

While in general regional banks do face higher relative risks from exposures to CRE, we believe select regionals are better positioned when considering the context of an improving operating environment. Expectations of interest rate cuts and new regulatory requirements, continued resiliency of the US economy, and solid capital levels above regulatory requirements even when including unrealized losses, should allow banks to improve their credit profile moving forward.

Bank Credit Spreads Performance

Given one of the toughest periods for banks in recent history, it begs the question if we may see a repeat of 2008 performance. During the 2008 Financial Crisis, bank credit spreads widened by over 600 basis points as small regional banks to large banks failed. Fortunately in the years that followed, we have not seen any spikes in credit spreads that rival that of 2008.

For instance, in 2011–2012 spreads only increased by about 200 basis points in response to the European Debt Crisis, and in 2020 spreads once again only widened by about 300 basis points due to COVID. This was mainly driven by new regulations that essentially required banks to hold more capital and cut certain activities — amongst other requirements — in order to reduce outsized impacts to the financial system. Given this more stringent regulatory environment, spread widening — under rapid interest rate hikes and some regional bank failures in 2022–2023 — was able to be relatively more measured. Today, spreads continue to recover due to the improvement in the operating environment, and they remain within typical spread ranges despite some idiosyncratic events in the headlines (i.e., NYCB).

Key Takeaway

Despite the collapse of some regional banks in the spring of 2023, the US banking sector remains sound and is in a much better position today than during the 2008 Financial Crisis — mainly thanks to more stringent regulatory requirements. The recent events surrounding NYCB do not alter the overall sector’s credit health, and it is more of an idiosyncratic story. We believe that while office CRE-related risks will persist, expectations of interest rate cuts and new regulatory requirements, continued resiliency of the US economy, and solid capital levels will create a better operating backdrop for the banking sector going forward.

For more information, please contact your advisor.