Earlier this year, three of the largest banks failed in a sequence of events that was dubbed the Banking Crisis of 2023. With the passage of time, fears that the three failures could foreshadow further failures and deeper woes seemingly subsided, though a wave of banking institution downgrades in August 2023 briefly rekindled concerns. More recently, things have been quiet. Does that mean it is time to sound the all-clear signal? Perhaps, but there are signs out there suggesting continued vigilance may be in order.
First of all, though it has happened quietly and largely off the radar screen, even after the dramatic failures of three large banks earlier this year, there have been further bank failures this year, albeit with less fanfare, perhaps because the more recent failures have involved banks that are much smaller than the three that failed earlier this year.
The most recent bank failure took place just this past Friday. As detailed in the FDIC’s official press release (here), on November 3, 2023, the Iowa state banking regulator closed Citizens Bank of Sac City, Iowa, and the FDIC appointed the Iowa regulator as the failed bank’s receiver. Citizens Bank was very small; at the end of its most recent fiscal quarter, the bank had assets of just $66 million. According to news reports, the bank’s failure was the result of soured loans in the commercial trucking industry. (Higher fuel costs, increasing insurance expense, driver shortages and related wage inflation are putting many commercial trucking companies under financial stress.) In a November 3, 2023 press release (here), the Iowa banking regulator stated further that the failure resulted from the “concentration of out-of-territory and out-of-state loans to one industry” causing the bank to incur heavy losses on some of those loans.
The Citizens Bank failure late last week is actually the second bank failure since the three large banks failed in the Spring, following the July 28, 2023, failure of Tri-State Bank of Elkhart, Kansas. The Kansas state banking regulator closed Tri-State Bank, and the FDIC appointed the Kansas regulator as the failed bank’s receiver. As of the end of the first quarter of 2023, Tri-State Bank had assets of approximately $139 million. The circumstances surrounding Tri-State’s failure are murky but highly unusual. According to news reports, the bank’s CEO was the victim of a “huge scam.” It is not entirely clear what happened, but the scam apparently may have involved crypto trading leading to huge losses.
It is always dicey to try to generalize from just a couple of data points, particularly given the very unusual circumstances involved with the Tri-State Bank failure. Though it could well be argued that the two most recent, small bank failures are isolated incidents, I still think are still some things to note about these bank failures. The first is that before Silicon Valley Bank failed on March 10, 2023, it had been about two-and-a-half years since any bank in the U.S. had failed. During that time, calm and stability prevailed in the banking industry; what changed is that in March 2022, the Federal Reserve began raising interest rates from the ultra-low levels that had prevailed in the years preceding. The rising interest rates created economic and business conditions that put stress on banks and their borrowers.
It is also noteworthy that the two most recent bank failures involved banks in the country’s heartland. The three large failures earlier in the year involved coastal banks with significant concentration in boom-and-bust industries. By contrast, Citizens Bank failed not only despite but because of its heavy concentration of a basic heartland business like commercial trucking. Citizens Bank failed because its borrowers are facing macroeconomic challenges – challenges of a kind that affect many industry sectors in this country, and that therefore affect the banks of companies in those sectors.
There is another reason why I think it is still too early to sound the all-clear on the Banking Crisis of 2023, and that is because intermittently throughout the year, even after the quick surge of litigation involving the three large bank failures earlier in the year, there have been additional securities class action lawsuits filed related to the turmoil in the banking sector.
First, on August 4, 2023, a plaintiff shareholder filed a securities class action lawsuit in the Northern District of Ohio against KeyCorp, the bank holding company for KeyBank, and certain of its executives. As discussed here, the plaintiff shareholder filed the lawsuit in the wake of declines in Key’s share price after bank executives announced reductions in the company’s earnings guidance, as the bank found itself required to pay higher interest rates to attract deposits.
Second, as discussed here, on September 11, 2023, a plaintiff shareholder filed a securities class action lawsuit in the Central District of California against PacWest and certain of its directors and officers. In July 2023, PacWest had announced its plan to merge with the Bank of California. PacWest struggled with the many of the same issues that had taken down Silicon Valley Bank, including large unrealized losses in its bond portfolio and significant amounts of uninsured deposits. The securities complaint alleges that the defendants had made misrepresentations in connection with the events surrounding the other banks’ failures and leading up to the July merger.
There is a further reason to continue to be concerned about the banking sector, and that is commercial real estate. As the Wall Street Journal has detailed, rising vacancy rates in office buildings has stressed the commercial real estate sector, putting many landlords in a difficult spot as they continue to try to service their debt. The well-publicized sector stress has in turn caused many lenders to pull back from the space, putting many borrowers in a position where they cannot roll over their debt as existing loans mature. The increased vacancy rate and the drying up of lending capacity increases the likelihood of commercial real estate loan defaults.
The net result is what the Wall Street Journal has called a “doom loop” that, according to the Journal, “threatens America’s banks.” The “doom loop” scenario involves the following stages: “losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.” How all this will play out remains to be seen, but the process won’t play out quickly; rather, it will, according to the Journal, be a “slow grind.”
Finally, for anyone naturally inclined to pessimism, there are a host of other reasons to be worried about what may lie ahead for the U.S. economy as a whole, not just the banking sector. Continued, persistent inflation, high interest rates, and truly dangerous geopolitical conditions cast shadows that confuse the near, middle, and long-term prospects – not to mention the fact that there is a Presidential election in 2024, as well.
While there are a number of reasons to continue to be concerned about the banking sector, there are nevertheless some reasons for optimism. At its most recent meeting, the Federal Reserve kept short-term interest rates unchanged for the second straight meeting; indeed, the Fed has raised interest rates only once since May 2023. While the Fed has carefully kept the door open for the possibility of further interest rate increase in the future, the possibility that the Fed may be done raising interest rates could take pressure off both banks and their borrowers.
A second reason to be hopeful is that after the flurry of large bank failures earlier this year, there have been no further large bank failures since. To be sure, there have been the two small bank failures mentioned above, but it could be argued that there is nothing about those two more recent failures that suggests systemic risk. The worst fears that loomed earlier this year seem to have been evaded.
It seems to be that the right approach for now with respect to the banking sector is continued watchfulness and wariness. The worst of the Banking Crisis of 2023 may well be past; the question that remains, despite the passage of time, is whether there is yet more to come.