Three major risks that have the banking industry on edge

Apr 11, 2023, 6:00 AM | Updated: Apr 12, 2023, 8:51 am

Utah Gov. Spencer Cox and state leaders were apparently preparing to be the backstop for short-term...

Zion’s Bank branch at 7015 South Highland Dr. Cottonwood Heights on Tuesday, March 14, 2023. Zions Bank and other regional banking institutions have suffered stock losses amid the fallout from the closures of Silicon Vally and Signature banks. While Zions and some other institutions that have drawn scrutiny and a wave of social media commentary saw big drops in their stock values early this week, all appeared to be recovering on Tuesday as wider fears about the U.S. banking sector ebbed. Scott G. Winterton/Deseret News

 (CNN) — It’s been one month since Silicon Valley Bank collapsed, triggering alarms throughout the halls of global banking industry.

The initial panic has settled into a more tolerable state of tension. We can all take a deep breath, knowing our money is safe and that banks have the tools they need, courtesy of the federal government, to weather the storm.

“We’re going from flashing red lights to flashing yellow lights,” Wells Fargo’s senior bank analyst Mike Mayo told me recently. “I think it’s time for hyper awareness and vigilance to anything else” that might further undermine confidence.

Regulators and investors are certainly on high alert. And they don’t have to look too far to find things to worry about.

Here’s the deal: SVB’s red flags — its breakneck growth, lax risk management, and over-reliance on uninsured deposits, among other things — should have been easy to spot before its collapse. Now, everyone’s looking for the next risk hiding in plain sight.

A consensus is forming around three key areas that analysts fear could create a systemic problem — commercial real estate, underwater bond portfolios, and the industry with the most metal moniker ever, shadow banks.

The toll of the WFH era

Commercial real estate — offices, apartment complexes, warehouses and malls — has come under substantial pressure, my colleague Julia Horowitz reports. Commercial property valuations could fall by roughly 20% to 25% this year, according to Rich Hill, head of real estate strategy at Cohen & Steers. For offices, declines could be even steeper, topping 30%.

Office properties are a particular pain point here. The average occupancy of offices in the United States is still less than half their March 2020 levels, according to data from security provider Kastle.

About $270 billion in commercial real estate loans held by banks will come due in 2023. Nearly a third of that, $80 billion, is on office properties.

Signs of strain are increasing. The proportion of commercial office mortgages where borrowers are behind with payments is rising, according to Trepp, which provides data on commercial real estate, and high-profile defaults are making headlines. Earlier this year, a landlord owned by asset manager PIMCO defaulted on nearly $2 billion in debt for seven office buildings in San Francisco; New York City; Boston and Jersey City, New Jersey.

This is a potential problem for banks, given their extensive lending to the sector. Goldman Sachs estimates that 55% of US office loans sit on bank balance sheets. Regional and community banks — already under pressure after the failures of Silicon Valley Bank and Signature Bank in March — account for 23% of the total.

“I’m more concerned than I’ve been in a long time,” said Matt Anderson, managing director at Trepp.

Unrealized losses

Back when interest rates were near zero, US banks gobbled up long-dated Treasuries and mortgage-backed securities. (And, typically, that’s a safe move if you make sure to hedge against the risk of those assets losing value — which SVB did not.)

But as the Fed and other central banks have raised interest rates aggressively, the value of those bonds has been eroded.

US banks are now sitting on an estimated $620 billion in unrealized losses — their assets are worth less now than they paid for them, making it a problem if the bank is forced to sell those assets in a crisis (like, say, a bank run).

That $620 billion is a conservative estimate, experts say. And it remains unclear where those unrealized losses loom — whether they are spread out across the sector or concentrated among certain kinds of lenders.

Shadow banks

As we discussed here last week, shadow banking refers to financial institutions that lend out money (like a bank) but don’t take deposits from customers.

They’re a large and diverse cast that includes investment banks, hedge funds, insurance companies, private equity funds, all manner of Wall Street power players.

The menacing nickname can be interpreted widely. They’re in the shadows because they’re unregulated, sure. But are they, like shady? Yes and no. Hedge funds and private equity types get a bad rap that is sometimes deserved, but they also provide financing to young firms that can’t get the time of day from regular bank-banks.

The key thing to remember is they’re not subject to the same strict rules as banks are, meaning they can take on more risk. They also don’t get the benefit of a government backstop if the wheels start to come off.

But bank-banks and non-banks overlap in all kinds of real and perceived ways, and when confidence is eroded on either side, that creates a potential for panic to spread.

The mere perception that the banking sector might be connected to a struggling non-bank could spark a broader financial crisis, as my colleague Anna Cooban explains.

Bottom line

One of the many troubling reminders to emerge from the SVB debacle is that banks are big, sprawling operations run by human beings, in service of other human beings, none of whom are entirely rational. That might seem simplistic, but it’s especially relevant for an industry as uniquely reliant on trust as banking is.

“This is not a zero-defect industry,” Mayo says. “This is an industry that tries to minimize losses of mistakes, just like any other industry…The reality is that there are going to be mistakes.”

He added: “This is a time when banks can reinforce the importance of their most important asset, which is trust.”

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Three major risks that have the banking industry on edge