2023 Banking sector turmoil: It’s not déjà vu all over again

Rahul Ghosh May 25, 2023 09:45

The recent failure of two smaller banks, Silicon Valley Bank and Signature Bank, has raised concerns about whether we are on the brink of another financial crisis, similar to the 2008 global financial crisis. However, I think that this is not the case, as the 2008 crisis was primarily a credit crisis driven by bad loans and poor credit underwriting, whereas the current crisis is a balance sheet crisis driven by an asset-liability mismatch. However, I believe that the banking sector turmoil will bring changes to commercial real estate market, the technology sector, and private markets.

Not a Re-run of the 2008 Financial Crisis

The failed banks, especially two U.S. smaller banks, Silicon Valley Bank & Signature Bank, focused on a risky and concentrated customer segment, rapidly grew deposits, extended loans when interest rates were low, and assumed interest rates would not quickly rise. This resulted in a risk management failure, triggering the crisis. However, the banking system in 2023 is fundamentally stronger than in 2008. The banking industry now has better capital and liquidity requirements and undergoes stress testing by regulators. Bank holding companies with total assets of more than USD50 billion also have living wills in place, allowing the federal government to take them over and unwind them in an orderly manner, if needed.

If there are further negative repercussions from the recent banking failures, they are unlikely to be systemic in nature, but we think they may change the nature of banking in the US in the medium term. Large banks are likely to get larger, as depositors prefer the safety of larger banks. There may also be an increase in the cost of funding and lower overall profitability, driven by increased competition for funds, potentially higher funding costs if banks diversify funding sources away from large uninsured deposits, and higher costs of capital across banks, especially for small- and mid-cap banks. This would likely imply lower net interest margins and return on equity for the sector, albeit with differences by region, scale, etc. The impact on the US economy is likely to be negative, although the quantum of impact is up for debate.

Commercial Real Estate Being Closely Scrutinized

The failure of Silicon Valley Bank and Signature Bank has raised concerns about the commercial real estate (CRE) market. MSCI estimates that there will be USD 900 billion of commercial real estate loans maturing over 2023 and 2024 that will need to be refinanced in an environment of higher interest rates, lower prices, and weakening demand. Given the importance of smaller and regional US banks in this space, this is a bigger concern for them than for larger banks. There has already been a sharp drop-off in CRE lending activity, which could have a negative impact on the availability of credit to businesses, especially those in the commercial real estate sector.

Tech Ecosystem Change is expected to Come
The banking sector turmoil may also bring change to the tech ecosystem. There could be a negative impact on the availability of funding for startups, which may result in more startups shutting down or selling their businesses. This could also have a knock-on effect on the venture capital firms that have backed them, causing them to take write-downs on their portfolios.

However, on the positive side, it may accelerate a push towards profitability as opposed to the growth-at-all-costs mentality that some tech startups have had in the past.

No Immediate Red Flags on Private Markets

Available information does not suggest immediate red flags in either the private credit or equity markets. However, given their size and growth, regulators are no doubt concerned there may be some hidden risks, and they will be watching the sector closely. Private equity (PE) and private credit (PC) funds are protected in crises by the fact that their end investors commit capital for long periods of time.

However, the risks for PE and PC funds are largely centered around valuations and re-financing risks and costs. If private market transactions occur that would impact how investments are held on their books or with higher cost of refinancing, that may lower prospective returns rather than impairing them. Given the amount of dry powder, it should not detract from the ability to do deals. However, it may change the nature of transactions to focus on deals that require less leverage or that can be primarily financed through equity. In a capital-starved environment, investors could theoretically extract better terms for deals that are completed.

For the PC market, the risk of defaults will have increased given that they typically lend to more leveraged companies. But opportunities will also appear, as banks retreat from extending loans to companies/private equity funds.

In conclusion, while there is a definite sense of "Déjà vu all over again," it is worth reminding ourselves of the differences to prior credit events. Investors should be aware of the increased risks as well as opportunities created by the recent banking turmoil, without needing to be overly bearish or bullish.

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Rahul Ghosh

Portfolio Specialist for T. Rowe Price's Global Technology Equity Strategy