Small banks, big problems

A banking crisis? What is this, 2008?

Think similar problems, but on a different scale, says TS Lombard economist Steven Blitz. He sees trouble on the horizon for small banks; they “look like they are heading for an unsettling mix of reduced funding and more underperforming loans”, he wrote in a Tuesday note.

Even after the US’s recent reprieve from tightening financial conditions — which is looking more temporary by the day — borrowing is more expensive than it’s been in years, for both banks and their customers. And smaller banks have low reserves, high funding costs and greater exposure to risky markets like commercial real estate.

Blitz compares the largest 25 banks (with about $160bn or more in consolidated assets) with the rest of the Fed’s list. He finds that smaller banks bring in a greater share of their income from lending:

While small and large banks both still have loan-to-deposit below pre-Covid levels, small bank loans and leases are 82% of deposits versus 88% before Covid — large banks are at 60% versus 70% pre-Covid. In 2012, loan/deposit ratios were similar at both banks.

Because small banks rely more on loans for their income, they have been “more aggressive in lending and in borrowing short-term liabilities to fund themselves”, according to Blitz. Large banks have also faced stricter regulations than their smaller peers since the financial crisis, so should be shielded from the worst of the pressure, he says:

“The race doesn’t always go to the swiftest or the fight to the strongest, but that’s the way to bet.”

One important part of his argument is that small banks’ funding bases are riskier than those of their larger peers.

As the Fed’s balance sheet shrinks, banks “are now sitting with reserves pretty much at their lowest comfort level — especially small banks,” Blitz says:

All banks have been borrowing more, but only small banks’ borrowing has reached pre-Covid levels as a share of reserves:

Small banks have lower amounts of cash on hand relative to their assets (loans, securities portfolios, etc), says Blitz. That means they have been resorting more to borrowing for funding, including at the Fed’s discount window, which he refers to as the DW:

The Fed has worked hard in the past several years to remove the stigma of borrowing from the DW (large banks helped in early 2020 as a show of good faith, not because they needed the money). Part of the Fed’s efforts included eliminating the primary credit penalty rate above the top end of the Fed funds target range and charging the same rate whether the money is for overnight purposes or term (90 days, for example).

This matters because banks have been getting more of their funding in the form of advances from Federal Home Loan Banks, or FHLBs, in recent years. Small banks’ shift to the Fed’s discount window has one less worrying explanation:

This is much more competitive than advances from the FHLB. Small banks, many of whom are private and therefore have no shareholder concerns regarding the optics of borrowing from the DW, have consequently shifted to using the Fed’s DW facility.

And one more worrying possible explanation:

There may also be another factor moving banks from the FHLB to the Fed for financing — the FHLB requires positive tangible capital. In 2022, small banks showed a drop in tangible equity capital to total assets, losses on purchased securities being one source of the change in this ratio — although, to be clear, only a tiny number had negative capital as of 2022Q3 call reports.

Small banks also have a greater share of large depositors. Regulators generally see larger depositors (especially companies) as a less stable funding base. Because the FDIC only insures bank deposits up to $250,000, the largest deposits are at risk in a bank failure, meaning those depositors are a little jumpier about bank credit, ready to withdraw cash at the first sign of trouble:

Is there a small bank funding crisis in the making? There is not much of a cash-to-asset cushion left for small banks (as a whole), so a funding crisis can easily get rolling if large depositors, generally uninsured ($250,000 is deposit cap for FDIC insurance), decide too many loans in commercial real estate and other areas are about to go bad. The Fed will make funds available to keep these banks afloat, the DW writ large, and would eventually merge the weakest small banks into healthier ones. That alone would get some push-back from Congress because of the increased concentration of bank deposits among an increasingly fewer number of banks. This concentration accelerated in 2008-09, when the Fed officiated over many shot-gun weddings to keep the banking system afloat.

But to really kick off a proper crisis, there would need to be a loan-performance problem — or, given small banks’ funding mix, at least worries about one. That’s where the argument gets a little trickier.

Blitz argues in the note that trouble in commercial real estate markets could be the catalyst. About 28 per cent of small banks’ loans are in non-residential real estate (excluding farms), he found, compared to just 8 per cent for the largest banks.

It seems reasonable to be more sceptical about that side of the scenario, though. While small banks are doubtless more exposed to CRE, they may not be as heavy into the big-city office spaces that face the biggest risk from the shift towards hybrid work. Broadly, CRE also can include shopping centres, grocery stores, small-town retailers and restaurants, and other non-office enterprises that are more protected from the hybrid-work trend. The inclusion of loans for farm properties, for example, boosts small banks’ CRE exposure by seven percentage points, compared to three percentage points for large banks. Remote work doesn’t work on a farm.

But even if you aren’t convinced that most small banks will be sunk (or acquired, more realistically) in a CRE market meltdown, the funding pressure on small banks could have broader implications for the US economy. Not only are small banks more reliant on loans for income, but Americans are more reliant on small banks for loans.

A decade ago, the total amount of small-bank loans and leases outstanding (in dollars) was just 45 per cent the amount of loans and leases made by the 25 largest US banks, according to TS Lombard. Today, small banks’ aggregate loan book is 70 per cent the size of large banks’.

Or as Blitz puts it: “While a 2008-09 banking crisis is not going to arrive . . . [banks’ decision to extend less credit supports] the argument that the economy is more likely to slow than advance in the coming months.”