On Banking Crisis Predictions

Following the failures of Silicon Valley Bank and First Republic Bank, some pundits are concerned that rising interest rates and credit costs could cause a new banking crisis. We propose the following framework, to think about this possibility.

While economic softness causes banks to lose money on their loan portfolios, rising credit costs don’t always lead to big spikes in bank failures. The U.S. has had 14 recessions since the Great Depression, including several that were preceded by rising interest rates and inflation. During this 93-year period, we only had two major banking crises with hundreds of bank failures – the Savings & Loan crisis of the 1980s and the Great Financial Crisis of 2008-2009 (GFC).

Banks fail almost every year. All bank failures since the Great Depression were at least partially a result of management mistakes. There are currently over 4,700 commercial banks in the U.S. Based on our experience, most of these banks aren’t managed by exceptional teams. A few are bound to fail regardless of economic conditions. In fact, over 200 banks failed over the past 13 years since the end of the GFC.

The growth of the U.S. economy is slowing. After running on steroids over the past two years, corporate profits are expected to decline in the second half of the year. Asset prices have declined from their peak due to inflation and rising interest rates. While some sectors benefitted from the post-pandemic recovery, the shift to work-from-home has been a major headwind to the office sector, particularly in large cities such as San Francisco. Higher interest rates will put additional pressure on borrowers as many refinance their loans over the next 1-3 years. These conditions are resulting in rising losses on commercial real estate loans, particularly loans for office buildings. We expect losses on commercial real estate (CRE) loans to rise if the economy continues to weaken and losses on office loans to keep rising over the next 1-2 years, regardless of economic conditions.

Losses on CRE loans have been near zero in the past eight years. During the GFC, losses on CRE loans peaked at 3.1%. Banks currently hold about $1.8 trillion in CRE loans. If we assume CRE loan losses reach double their level during the GFC, losses will peak at $100 billion. Given that banks reported net income of $263 billion in 2022 and reserved $195 billion against future loan losses, we think the industry has the financial capacity to manage through an extreme rise in loan losses. But since small banks are more exposed to CRE loans than large banks, we expect more small banks to fail in the coming years.  However, we don’t expect these failures to cause a full-blown banking crisis.

It’s important to note that the banking industry has become more consolidated. The largest most regulated banks dominate the industry and failures of smaller institutions have less of an impact than before the GFC. In 2006, the banks with assets greater than $10 billion controlled 75% of total bank assets. At the end of 2022, banks with assets greater than $10 billion held 85% of total bank assets, and 55% of total bank assets are now controlled by the 13 largest banks in the country.

The largest commercial banks in the country are subject to stringent regulation, annual stress tests, and onerous capital and liquidity requirements. The stress tests are designed to ensure that the largest institutions in the country can make it through depression-like conditions without raising capital or seeking government support. If smaller institutions fail due to mounting CRE loan losses, larger banks will be able to assist the FDIC in the clean-up work, thereby reducing the biggest economic risk of a banking crisis, which is a credit market freeze.

With this in mind, we think the economy will continue to weaken and bank loan losses will rise, but the probability of another major banking crisis in the next 1-3 years is low.

In terms of what impact this has on our investment decisions, it’s important to note that our investment approach doesn’t change with economic conditions. We always look for competitively advantaged businesses that are in a strong financial position and are managed by talented teams that can create value by growing the earnings power of the businesses they oversee. When we evaluate these businesses, we want to make sure they can withstand very tough economic conditions and crises and thrive over the long term regardless of short-term conditions.

It’s also important to remember that while we focus on long-term business fundamentals, many market participants are short-term oriented, which is why stocks are volatile. It’s possible that additional economic weakness or rising bank losses will lead to additional volatility in bank stocks and the broader market. We cannot time the market or predict when a stock selloff begins or ends. It’s impossible to predict recessions and it’s even more difficult to predict when or by how much stocks will fall in response to one, or when stock prices will recover. Given these limitations, we play defense by owning resilient businesses that are built both to survive recessions or major crises and also thrive during the inevitable recoveries. At the same time, any market selloff will create new opportunities. Our offensive game is to evaluate new ideas that might arise in such an environment.

Interested in learning more about how we view current events? Contact us today!