Rob Hajduch, Managing Director, Taxable Credit Research

With a year removed, the benefit of hindsight, and a broader view of historical context, it has become apparent that the string of regional bank failures in the spring of 2023 did not represent the existential systemic threat it seemed to at the time. Contributing to the shock value were several factors, including the fact that the three failures igniting the crisis were clustered over a mere 10 weeks, with the first collapsing over a period of roughly 72 hours. Additionally, the concurrent resolution of Credit Suisse by Swiss regulators did not positively contribute to the general sentiment toward banks. Ultimately, Silicon Valley, Signature, and First Republic shared several characteristics that contributed to their failures, including lending and deposit relationship concentrations, an outsized representation of uninsured deposits in their bases, long duration investment portfolios in the face of rapidly rising interest rates, and weak risk management functions. 

The FDIC-assisted resolution of First Republic Bank in May 2023 represented a watershed moment on two levels. Most importantly, it clamped a lid down on the violent widening in regional bank credit spreads following Silicon Valley Bank’s failure. Longer-term, JPMorgan Chase’s participation in the resolution reignited debate on industry consolidation and concentration, as well as triggering calls for enhanced regulation for a larger cohort of domestic banks and higher capital requirements for all banks to prevent similar events in the future.

We fully concur with the concept of better regulation of regional banks but viewed the asset size categories established by the tailored regulatory approach established in the wake of the global financial crisis (GFC) as being arbitrary. This was underscored by the events of early 2023, as the three failed banks all fell into the third category, with lower regulatory capital and liquidity requirements and less frequent stress testing.  

However, angst regarding failures and consolidation is unwarranted in our opinion. Bank failures are a part of the natural order of the industry, and years with no reported failures are exceptionally rare. Over the 90 years since the FDIC began keeping records in 1934, a total of 4,109 commercial banks have failed, with a total of five annual periods in which there were no failures. All the failure-free years have transpired since 2000, of which three have occurred since 2017, including the two years preceding the regional bank crisis last year. 

When viewed against the two prior periods of genuine economic turbulence, the failures in 2023 barely register. Even the GFC pales by comparison to the genuine carnage that occurred across 1984 to 1993, when the overlapping farm crisis and Saving & Loan debacle culminated in the failure of 2,640 commercial banks. Subsequent failures brought the total number to 3,572 by the end of 2023. New charters exceeded failures across that period however, with a net 411 net new banks (blue bars in the preceding chart) created to replace those lost (red bars). 

Incidentally, the number of banks supervised by the FDIC peaked in 1984 at 14,507, and the number of institutions has declined steadily over the following four decades to 4,036 at the end of 2023. As net new chartered banks exceeded failures over that period, the implication is that the shrinkage was driven by voluntary mergers or business cessations.

Motivations for merging vary, although technological innovation certainly ranks high among them. The spread of the internet in the 1980’s foreshadowed an increased volume of banking business conducted remotely, and presumably more efficiently than that performed in person at branches. Adoption was incremental, however, and even as the system consolidated, the number of branches continued to increase before peaking in 2009. The number of physical locations operated by the system was relatively stable over the subsequent two years before beginning a steady decline until 2022. 

The increase in branches was ironically driven by the same economic factors that drove the subsequent decline. Operating a branch is more efficient than operating a standalone bank, which requires a charter, management team, and board of directors, among other necessities, and sourcing deposits and distributing products and services digitally is more efficient than doing the same in a physical location. As internet usage became more ubiquitous, banks began to optimize their physical footprints to drive positive operating leverage. The process accelerated with the COVID pandemic, with social distancing and remote working arrangements common, and led to the system shedding nearly 10% of the branches in operation at the end of 2019 by the end of 2022. 

Total branch numbers stabilized in 2023 as branches opened in markets with more attractive demographics, replacing redundant and underperforming branches in slower growth markets. Investment in digital platforms and risk management systems is perpetual, however, and further consolidation among smaller banks is expected to render those capital expenditures more affordable. 

Ultimately, we view consolidation as a credit positive as fewer, larger institutions benefit from better geographic and product diversity, expanded reach in gathering deposits, and the opportunity to improve operating leverage by spreading expenses over a broader revenue base. All the preceding contributes to earnings stability that in turn allows for more consistent organic capital generation. Industry consolidation is a natural evolution driven by a changing environment. Finally, large diversified banks are actionable from an investment standpoint as they more consistently issue debt in the capital markets, with the largest and most diverse typically benefitting from higher credit ratings. 

Sources

https://banks.data.fdic.gov/explore/historical/?displayFields=STNAME%2CTOTAL%2CBRANCHES%2CNew_Char%2COFFICES%2CUNIT%2CBRANCHIN&selectedEndDate=2021&selectedReport=CBS&selectedStartDate=2014&selectedStates=0&sortField=YEAR&sortOrder=desc

https://www.fdic.gov/resources/resolutions/bank-failures/failed-bank-list/

USBAM Research