Over the course of several weeks from March to early May this year, three large U.S. banks failed in a sequence of events that has come to be known as the Banking Crisis of 2023. Fears arose at the time that the bank failures could become a contagion event across the banking industry. With the passage of time since the most recent failure, there seems to be a general perception that the banking crisis has subsided. But even though the situation may have calmed down, concerns remain that there could be more of the story to be told about the 2023 Banking Crisis. What should we be worried about, and what are the signs to watch for?

There is an important context for these questions about what may be next for the current banking crisis. We don’t have to go that far back in time to consider a relatively recent sequence of events where a financial crisis unfolded gradually, over the course of several months. Readers will recall that while Bear Stearns collapsed in March 2008, it was more than six months later, in late September 2008, that Lehman Brothers collapsed. Those prior circumstances are a reminder that financial crises don’t necessarily unfold rapidly. And the likely sequence of future events is not always apparent as the process unfolds.

At least some authors – for example, economists from The Conference Board, in a recent paper (here) – have suggested that “the worst of the banking crisis appears to be over.” But even those taking a relatively upbeat perspective on the recent banking industry events remain watchful and wary. There are undeniably several sources of stress in the financial markets, with effects felt in the banking industry and throughout the financial services industry.

The first and most consequential stress in the financial markets is continued economic inflation, which has persisted notwithstanding active steps by the Federal Reserve and other central banks to try to tame the inflation through interest rate increases. Indeed, the Fed raised interest rates at ten consecutive meetings starting in March 2022 and going through May 2023. To be sure, at its most recent meeting earlier in June, the Fed kept the rate steady – but also signaled that it was prepared to continue its interest rate increases if signs of inflation continue.  Indeed, because of “stubborn inflation,” policymakers have “penciled in” two more rate increases for later this year, which would bring interest rates to the highest level since 2001.

Continued inflation, and the interest rate increases calculated by policymakers to try to tame inflation, create (at least) two sources of financial stress. First, further interest rate increases will increase pressure on interest rate sensitive businesses, including banking institutions. Banks hold long-dated bonds and loans that diminish in mark-to-market value as interest rates rise. (This sequence of events was one of the circumstances that took down SVB). Increased interest rates will exacerbate this effect.

Second, rates could rise to the point that the economy begins to stall, leading to an economic recession. To be sure, late last year and earlier this year, many economists were predicting that a recession would have developed by about this time in 2023; for a lot of reason (including greater resilience in the U.S. economy than anticipated) the predicted recession has not yet emerged. However, there are persistent signs that the threat of recession is continuing.

One is that current interest rates reflect an inverted yield curve, meaning that interest rates on long-term bonds are lower than interest rates on short-term bonds. An inverted yield curve is generally believed to be a sign of a coming recession. Indeed, an inverted yield curve has emerged in nearly every recession in the last 60 years.  There may be signs that the slowdown has already started in some economies, as the pace of economic activity appears to have cooled in the Eurozone, Japan, and Australia, even if not yet in the U.S. Were a recession to emerge, it would mean a slowdown in business activity. For banks, it could mean slower collections, and perhaps even defaults or bankruptcies.

There is another reason to be concerned about the general economic environment in which banks are operating, and that has to do with commercial real estate. The COVID-19 pandemic continues to cast a shadow over the commercial real estate sector. The transformation of working patterns and habits from the pandemic, as more employees work from home or work only a hybrid office work schedule, has caused commercial vacancies to soar.

The trouble in the commercial real estate sector translates to potential problems for banks. Commercial real estate loans make up a significant proportion of many small and regional banks’ loan portfolios. Unfortunately, defaults and delayed payments on commercial real estate mortgages are already emerging.  The risk to commercial real estate lenders includes not only the risk of increased delinquencies, but also the risk associated with declining property values. The decreased values diminish the value of collateral backing loans, and also inhibits borrowers’ ability to refinance or otherwise maintain credit. Regulators have signaled their concern about banks’ vulnerability to commercial real estate weakness, particularly with respect to banks with high concentrations of commercial real estate loans.

Banks are under other pressures as well. For example, many smaller banks are finding that they must pay higher interest rates to attract and retain depositors. These pressures undermine the banks’ profitability as the higher rate payout erodes their margins from interest income on outstanding longer-term loans. Indeed, recent comments from Treasury Secretary Janet Yellen suggest that she and other government officials expect that these forces could translate into continued tumult in the banking industry later this year, and at a minimum could cause more lending institutions to merge.

In light of these identifiable economic stressors, and in the context of the forces that triggered the collapse earlier this year of three large banks, there arguably are a few identifiable specific bank characteristics to consider when assessing individual banks.

First, given that at least two of the three banks that failed this year failed after massive bank runs, one factor to look for is significant amounts of uninsured deposits. (Uninsured deposits are deposits in excess of the FDIC’s maximum insurance limit of $250,000). Both SVB and First Republic had significant amounts of uninsured deposits; when signs of trouble emerged, spooked investors pulled their funds from the bank.

Second, depositors at institutions with significant mark-to-market losses on their bond portfolio may be likelier to withdraw their deposited funds, if they perceive that the bank could not realize sufficient liquidity to honor withdrawal requests. In a study earlier this year, following the SVB and Signature bank failures, academics calculated that as many as 190 U.S. banks with assets totaling $300 billion are “at a potential risk of impairment,” meaning that if only half of uninsured depositors decided to withdraw, the mark-to-market value of their assets after those withdrawals would be insufficient to pay all insured deposits.

Third, while weakness in commercial real estate sector is a vulnerability to the entire banking industry, the commercial real estate problems are not uniform. Not all geographic areas are suffering the same levels of vacancies. Not all commercial real estate sectors are under pressure; for example, the agricultural sector remains sound. The level of an individual bank institution’s concentration in commercial real estate and the distribution of the commercial real estate exposure could illustrate the extent of the threat to the bank from the sector.

Fourth, the make-up, concentration, and distribution of maturities in the bank’s asset portfolios, as well as the existence of interest rate risk management safeguards (such as, for example, interest rate hedges) will all be important in understanding the extent of the interest rate risk facing the bank.

I am certain that readers who specialize in underwriting banking institutions could add to or expand upon this list of key factors. I invite those who have further insight on these issues to add their thoughts using this site’s comment feature.

But in any event, I think the point is clear – that while it appears that the banking crisis of 2023 may well have subsided, we may or may not be entirely out of the woods. There are obvious indicators that there is continued stress in the banking sector. As I said at the outset, there may be further to be told in the story of the 2023 banking crisis.