Earnings Watch: Uninsured Deposits & Commercial Real Estate Loans Are the Focus

As banks report earnings, two concerns will dominate all others: uninsured deposit levels and commercial real estate lending data. It is the regional banks where both stresses seem to be concentrated and where earnings will be most informative. But CRE will be a challenge for many community banks as well. Once the data is in hand, the next step will be to figure out how to mitigate these industrywide challenges in the long term.

Bank earnings season will open an important window into the health of the U.S. banking system in the wake of recent bank failures and broader economic challenges.

Unrealized bond losses will get a lot of attention and, while serious in terms of impairing banks’ ability to lend, that topic is also largely yesterday’s news. Overall, banks have about $620 billion in unrealized losses equal to about one-third of capital, and many will need to raise capital or shrink to address the resulting balance sheet holes. But since rates have been relatively constant through the first quarter and banks have already disclosed mark-to-market losses for yearend, there likely isn’t much left to uncover. [A new factor will be the Federal Reserve’s Bank Term Funding Program, created in the wake of the failures.]

The real insights out of earnings season will come from what publicly traded banks reveal about two other stresses playing out behind the scenes until now:

  • The likely reallocation of uninsured deposits from regional banks to the largest banks.
  • The simmering commercial real estate (CRE) challenges facing regional and community banks.

These two sources of stress will have a much bigger impact on the strength of the banking industry, and the economy as a whole, than the gut punch of the two large regional bank failures of mid-March.

Stress Point #1: Uninsured Deposits on the Move

About 40% of total bank deposits are not fully insured because the balance exceeds the Federal Deposit Insurance Corp. coverage cap of $250,000, which was selected with a household in mind. Often, uninsured deposits are accounts that are inherently and necessarily larger, such as company operating accounts, endowments and wealth management accounts.

For three days in March, between Friday, March 10 (when the FDIC seized Silicon Valley Bank and explicitly said uninsured deposits were not protected) and Sunday, March 12 (when FDIC took over Signature Bank in New York and announced that uninsured deposits at both of the failed banks would be covered), the federal government inadvertently sent a message about how size matters. Its actions underscored how an implicit backstop for uninsured deposits might be based on the size of a given bank.

Deposit Insurance Quandary:

Whether the so-called 'market discipline' that follows such uncertainty is a good thing, the resulting situation is delivering it.

Depositors have long presumed community banks would not benefit from a “too big to fail” government backstop nor from the special emergency treatment under systemic risk determinations that were applied in the case of the Silicon Valley and Signature bank failures.

As a consequence, smaller banks typically don’t rely heavily on uninsured deposits. That can be a competitive disadvantage, but the lower level of uninsured deposits means community banks are relatively insulated from any reallocation of uninsured deposits. In fact, the whole recent saga has likely turned out to be a non-event for many smaller banks.

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Regional Banks Face Tougher Funding Pressure

Regional banks have seen a very different story playing out. They rely just as heavily as the largest banks on uninsured deposits. The recent failures were among the largest of regional banks, so the three days of government hesitation caused uninsured depositors to rethink exposure to a broad array of regional banks.

On review, depositors may be comfortable with the counterparty strength of a given regional bank. But where the uncertainty about uninsured deposits meets uncertainty about the strength of a given bank, depositors are acting. They are shifting what may amount to hundreds of billions in uninsured deposits into government securities; reciprocal deposit programs and similar efforts, which cost more to facilitate; and banks with a perceived stronger implicit backstop — the biggest banks.

“The movement of even a modest proportion of the $2 trillion in uninsured deposits held by regional banks would have profound implications for the banking system.”

— Brian Graham, Klaros Group

The federal government has acted aggressively to make short-term liquidity available to offset any deposit outflows at impacted banks. Even the extraordinary funding being made available is much more expensive than any uninsured deposits it may replace.

If sustained, the shift would hamstring the competitiveness of regional banks while perversely putting the largest U.S. banks at an advantage. As an illustration, based on public surveys, JPMorgan Chase and Bank of America are currently each offering only 1 basis point for a regular savings account, while some regional banks are forced to offer as much as 450 basis points for a similar deposit. That’s a massive funding advantage for the giants.

What forthcoming earnings tell us about which banks are likely winners and losers in the fight for uninsured deposits could define the future structure of the industry.

Read More: Deposit Stability Matters More Than Low-Cost Money Now

Stress Point #2: The State of Commercial Real Estate Lending

Rising interest rates have hurt the value of real estate collateral, just as with bonds, putting commercial real estate under stress. Post-pandemic shifts in shopping and working patterns are fundamentally decreasing demand for office and retail properties.

Office vacancies have now surpassed the peak of the global financial crisis, approaching levels last seen during the S&L crisis.

CRE Troubles Are Brewing:

Industry analysts are predicting declines in the value of CRE properties in the 10%-20% range, implying the probability of future losses on CRE loans.

Banks are heavily involved in CRE lending, particularly regional and community banks. Together the latter hold 80% of CRE bank loans despite having only half that proportion of industry assets.

Not all CRE loans are alike, of course. Such factors as property type (e.g., office, retail, multifamily, industrial), loan-to-value ratio, debt service coverage and geography, etc., will drive differences in performance. For banks with exposure to stressed CRE borrowers, pressures will translate into higher loan losses, higher expenses and lower revenues.

If this cycle plays to its frequent form, banks with stronger CRE loan characteristics will be most forthcoming about CRE at this early stage. Buried in the financial reports of all banks, though, will be early but essential insights into the breadth and depth of these challenges that will play out over years.

Read More: On Bankers’ Minds: Deposit Insurance & Regulatory Overload

What Are the Long-Term Solutions for These Stress Factors?

Merely assimilating the data that’s coming out is only the beginning. The industry must use the data to weigh appropriate actions for the future.

By all means, pay close attention, beginning with this quarter’s bank earnings reports. But it is important to avoid the temptation to “fight the last war.” Instead, executives must focus on the longer-term structural stresses at work involving uninsured deposits and CRE, as well as other issues that arise as more institutions release their numbers.

For now, the largest banks are well positioned, benefiting from an inflow of uninsured deposits while having lower levels of CRE exposure. Many community banks will be challenged by CRE losses over the next few years but are insulated from any realignment of uninsured deposits.

Ultimately it will be the regional banks where the stresses seem to be concentrated, and where earnings will be most informative.

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