Regional Banks Battle Liquidity Crunch

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The latest troubles at New York Community Bank have some observers wondering whether it could be a canary in the coal mine for the broader regional banking sector. Regional banks are definitely in a tough spot due to deposit flight, higher funding costs, and concerns about problematic commercial real estate loans. But, at least for now, troubles seem to be limited to a few isolated cases, rather than systemic.

New York Community Bank is the latest example of a bank that is wrestling with a specific issue. The bank came under fire after reported losses of $252 million in the fourth quarter, which triggered a sharp drop in stock price for the institution. Its challenges are related, in large part, to its acquiring a chunk of the failed Signature Bank’s commercial real estate portfolio last year. Its situation is getting a lot of attention in a market that is hypersensitive to any signs of bank stress as it nears the first anniversary of bank failures at Silicon Valley Bank, Signature Bank, and First Republic Bank,

“I don’t think it’s necessarily a crisis,” says Nathan Stovall, director of the financial institutions research team for S&P Global Market Intelligence. “Looking back at March 2023, there were clearly some institutions that had issues, and there will be more banks that struggle,” he says. But Stovall views those banks as outliers to the broader industry and not as a sign of safety and soundness issues in the banking sector, or for regional banks in particular. The banks that failed last year all had assets tied up in longer-duration assets, whether loans or securities, which meant that when rates went up, they were underwater.

Mortgage Bankers Association

Pressure on liquidity

What most of the regional bank space is facing is a lot of pressure on liquidity, alongside funding costs that are continuing to move higher. At the same time, regulators are asking many regionals to increase reserves and keep more cash on hand. “I think that leaves us [in] a place where regional banks are going to grow more slowly, and they’re going to make fewer loans,” Stovall says. Regional banks also are likely to experience higher losses from problem commercial real estate loans, particularly in the office sector, which will put more pressure on earnings, he notes.

“I don’t think there’s a banking crisis; it’s more of a lack of liquidity issue,” agrees Michael Riccio, a senior managing director and co-head of National Production for CBRE Capital Markets Debt & Equity Finance. The lack of loan payoffs and loss of deposits has really put a wrench into the system for many banks, and they are guarding their liquidity, he says.

Deposits are falling from record-high levels accrued during the pandemic as individuals and businesses spend down the cash they had accumulated, in part from unprecedented stimulus by the government. Depositors also are moving money out of zero-interest or low-interest bank accounts in favor of higher-yielding money market accounts or CDs they can find elsewhere. According to the St. Louis Fed, deposits held at all commercial banks, which peaked at $18.1 trillion in May 2022, have dropped by roughly $500 billion as of mid-February.

Regulators increase scrutiny

A big hurdle for regional banks is that growing to $100 billion-plus in asset size marks a key regulatory threshold. They are subject to tougher regulations, including expanded Basel III regulations, as well as higher capital liquidity requirements. According to a CNN report, New York Community Bank CEO Thomas Cangemi blamed the bank’s poor quarter on its acquisition of $40 billion of assets from Signature Bank, which brought the bank’s total assets above $100 billion.

“While the Fed doesn’t believe there to be a systemic crisis in the regional banking sector, we expect continued pressure for banks in 2024 and into 2025,” says Alison Williams, executive vice president and head of the Small Balance Group at Walker & Dunlop. According to the MBA, banks hold $441 billion in commercial real estate loans maturing in 2024. Higher borrowing costs will make refinancing more difficult; thus, banks will continue to enforce tightened credit and underwriting standards, as well as burdensome restrictions, resulting in reduced lending and market share.

Is the regional bank model broken? “The regional banking model is not broken in my opinion, but the landscape has greatly changed,” Williams says. With greater regulation—the implementation of Basel III, for example—on the horizon, regional banks will have to decide whether they want to staff appropriately to enforce stricter regulatory and capital requirements or look at alternative options, like acquisitions or mergers, to be able to scale to meet the ongoing needs of their customers, including real estate lending, she says.

Essentially, a $100 billion regional bank could be subject to much the same regulation as a big bank but lack the tools and resources of a larger bank. “It is more challenging, but I don’t think it’s broken, per se. I just think that it makes [things] harder,” Stovall says. One could certainly make the case that it’s tough to be a $101 billion bank. A bank would rather have more scale and resources at $200-plus billion, or stay below the $100 billion threshold, he says.

It’s also difficult to paint the entire regional bank sector with the same brush. Each bank has its own constraints, based on a variety of different factors. “There are still some banks that are active in [commercial real estate], while others are really overconcentrated in the sector and have to be cautious going forward,” says Lonnie Hendry, CRE, chief product officer at Trepp.

According to the St. Louis Fed, although “there are no hard limits on [commercial real estate] lending, [bank] supervisors may subject banks to extra scrutiny when total [commercial real estate] loans exceed 300 percent of risk-based capital and the [commercial real estate] portfolio has increased by 50 percent or more in the prior 36 months.” According to Trepp, there are numerous regional banks that exceed the 300 percent concentration ratio, including New York Community Bank, which as of third quarter data was at 468 percent.

Trepp

Banks maintain conservative lending

The health of regional banks is critical for the commercial real estate industry as they have traditionally been a major source of funding. According to the MBA, depositories (banks, in this case) currently hold roughly $1.76 trillion of the $4.7 trillion in outstanding commercial real estate and multifamily debt in the United States, based on year-end 2023 data.

Borrowers have been feeling the effects of tightening credit from regional banks over the past 12 to 18 months. “We’ve seen a pullback in the appetite of regional banks for making new [commercial real estate] loans. Overall, depositories had the greatest decrease in year-over-year mortgage originations in 2023, and to start 2024, anecdotally we are hearing that many continue to pull back,” says Susan Mello, executive vice president and group head, Capital Markets at Walker & Dunlop. “I don’t think any regional bank would say they are on the sidelines completely. Instead, they would tell you they are focused on relationship banking—looking to preserve and deploy capital for customers with whom they have more than a lending relationship.”

Lower interest rates could help thaw liquidity for regional banks. Lots of loans have been extended and extended, which is contributing to the lack of liquidity. At some point, those loans will have to pay off, and that also will help liquidity. In addition, there is a lot of capital ready to fill the void. “The problem with that capital is, it’s much more expensive,” says Riccio. For developers that have razor-thin margins, and that loan that is now maybe 200-plus basis points higher than what a bank would charge, that’s going to put a lot of developers on the sidelines. The numbers just don’t work, he notes.

Investors hope to capitalize on stress

The commercial real estate industry also is keeping a close eye on regional bank stress in hopes of finding investment opportunities to acquire distressed loans or REO properties. It remains to be seen just how much bad loans could back up in the regional banks. “There’s a lot of money on the sidelines chasing that opportunity, and no doubt there will be some of those [opportunities] ahead,” says Stovall. Stovall estimates that commercial real estate losses for regional banks could increase by multiples of two times or three times what they are today, but relatively speaking, that would still be incredibly low, considering that commercial real estate loan delinquencies held by banks are still less than 1 percent.

There have been examples of discounted commercial real estate portfolio loan sales, and there are likely to be more of those sales on a one-off basis. In addition to the sale of the Signature Bank real estate portfolio last year, the Financial Times reported that HSBC USA is reportedly in the process of selling hundreds of millions of dollars of commercial real estate loans, potentially at a discount. The issue is that banks are going to be reluctant to sell and take a big markdown on values compared to what they have on their books.

Banks are working with their borrowers to modify and extend maturing loans. They don’t want to take properties back and then sell them at what could be the bottom on pricing. In addition, regulators have been quite clear that they are asking banks to slow growth and build reserves, but they are not asking them to “blow out” their books, notes Stovall. “There is a lot of private money out there [with hopes] to get stuff on the cheap,” he says. “Some of those deals will happen, but I don’t think that you’re going to see as much capital be put to work that way.” Where private capital is likely to find more opportunities to be put to work is in direct lending as banks remain cautious on commercial real estate and construction lending, he adds.