So far 2023 has been a very bad year for the banking sector. The monetary policy U-turn, spearheaded by the Federal Reserve, but quickly adopted by other central banks too, put immense pressure on the banks, and it didn’t take long for the cracks to start showing.

The persistent and prolonged interest rate hikes caused the value of bank bond holdings to plummet. Especially in the US, this was combined with the so-called“Tech Winter”, that saw stock prices of Big Tech giants tumble, but also affected tech start-ups, that had their funding slashed. These were the dynamics that caused the first domino to fall: the tech-heavy Silicon Valley Bank, the 16th largest bank in the country and the biggest one to default since 2008. Officials were quick to respond, to guarantee deposits, but most of all, to assure investors and the public that this would in no way be anything like the last recession. However, fears spread anyway and bank stocks took a serious hit. Two more banks crumbled in the US after that, as well as Credit Suisse in Switzerland, a global player and not one of the Swiss private banks we work with, which have very different business models.

Although it might seem like some calm has returned to the sector recently, investors should remain vigilant, because in all likelihood this sense of being “back to business as usual” will prove to be temporary. The banking crisis is far from over. In fact, we might very well be seeing the makings of the next wave of bankruptcies and the epicenter of instability this time could be in the very troubled commercial real estate (CRE) sector.

Regional banks: a cornerstone of the “real economy”

Although most investors and most American citizens had never even heard of Signature Financial or First Republic before their collapse, or of any of their peers for that matter, regional banks are the backbone of the US economy. They are essential to economic growth, as they provide the majority of credit support to small businesses and ordinary households. They provide almost one-third of small business financing, which in turn generate two out of every three new jobs in the nation, according to the Small Business Administration. Also, as a recent Goldman Sachs analysis showed, banks with less than $250 billion in assets are the source of around 60% of all US mortgages, 80% of all commercial real estate loans, and 45% of all consumer loans.

However, this is all now under threat. The aforementioned pressures emanating from the higher interest rate environment - the bond portfolio markdowns - were already worrying enough, but the fear caused by the defaults also led to record levels of deposit flight, placing many regional banks in a very precarious position. The KBW Regional Banking Index is already down about 30% since March 8. And now, alarm bells are ringing increasingly loudly, as trouble in the CRE space could be the undoing of many of them, causing a domino effect and creating a perfect storm.

Small banks hold close to 70% of CRE loans and according to a report by JP Morgan, “compared to big banks, small banks hold 4.4-times more exposure to U.S. [CRE] loans than their larger peers. Within that cohort of small banks, CRE loans make up 28.7% of assets, compared with only 6.5% at big banks. More worrying, a significant percentage of those loans will require refinancing in the coming years, exacerbating difficulties for borrowers in a rising rate environment.”

The credit that regional banks provide, the oil that greases the entire economy, has already tightened considerably: in fact, US bank lending shrank by the most on record in the last two weeks of March. However, it could grind to a halt if the CRE crisis materializes. This could be the next trigger of a much wider and much deeper banking meltdown.

The trouble with CRE

The problem, in a nutshell, is that there’s too much empty real estate. Office space is a particularly severe pain point. The covid-induced remote work phenomenon is still here and most likely it’s here to stay. The current level of remote work remains 7 times higher than it was in the pre-covid days. For example, only 20% of financial services firms require full-time office attendance, according to a new survey by Scoop and across all industries, around 50% of companies insist on employees working three days a week on-site, while 41% require just two days.

As Reuters highlights: “The current overall vacancy rate of 12.5% is comparable to where it was in 2010, one year after the onset of the Global Financial Crisis.” Of course, it’s not only the pandemic working habits that stayed with us that are at fault. The massive and persistent waves of corporate layoffs and downsizing efforts, especially in the badly battered tech sector, have also contributed considerably to the weakened demand for office space. As might be expected, the high vacancy rates have had a heavy impact, but what might be more surprising is just how heavy it has been: no rent is being paid on 1 in 5 of all US office space.

It is also important to note that its not just office space that’s struggling. Retail too is under pressure. The rise of e-commerce over the last decade has slowly but surely decimated demand for physical brick and mortar shops, as evidenced especially clearly by the demise of the American mall. Demand has shifted to logistics facilities and warehouses instead, and as though the ease and convenience of the online shopping competition weren’t enough, physical retail also has to contend with the added challenge of inflation. According a survey by Mirakl, ”89% of global consumers say inflation has made them look for better value when shopping – and 75% are moving more of their spending online in the next 12 months to find that value.”

Adding another, and arguably more serious, layer of concern is the fact that by nature CRE assets are particularly vulnerable to higher interest rates. Even if interest rates simply stay where they are, or even slightly decline, a CRE crisis could still emerge, because there are loan renewals coming up in the next few years that can only be done at massively higher interest rates. And this would come at a time when both landlords and tenants are already financially weakened.

Investment implications

The deteriorating outlook of the CRE space and the extent to which regional banks are exposed to it could very easily trigger a severe banking crisis and an avalanche of bankruptcies. The remedy that worked in previous bank failures this year, the Federal Deposit Insurance Corporation (FDIC) is extremely unlikely to be of any meaningful use in that scenario. The FDIC is an independent US agency that member banks fund, and it is meant to protect deposits, up to $250,000, in the event a failure. However, it is dangerously underfunded and in no position to respond to a more widespread banking crisis.

What’s more, in the case of the SVB failure, most deposits were above that amount and thus uninsured, which is why the US government had to step in and guarantee all funds, to avert investor panic. That is not a realistic solution either in the case of multiple bank collapses, neither can we expect every failed regional bank to be bought by a big one. The only remaining option in that case would appear to be the return to the bail out approach, something that would be politically untenable and could trigger severe sociopolitical tensions. Yet, even if that road is taken, it is not certain at all that it will be enough to stabilize the banking sector.

Finally, investors must keep in mind that the situation doesn’t have to deteriorate to this point for substantial risks to emerge. Even before we reach a serious dead-end like this, or even if we never do and disaster is somehow averted, investors need to consider what will precede it and what dangers like ahead. As struggling regional banks keep tightening their lending standards, small and medium sized businesses will face either higher costs or just lose access to financing. The same is true for households, as they are bound to lose their credit lines too. All this is bound to have a seriously detrimental impact on the economy and given that we’re already veering worrying close to a recession, this could make sure it will be long and painful one. For this reason, we at BFI Infinity remain very cautious and vigilant and prefer an active and selective investment approach for the future, in which risk management considerations and tools are an essential component.

Legal Disclaimer

This report was prepared and published by BFI Infinity Inc., a Swiss wealth management company registered under the U.S. Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC) as an investment advisor.

This publication may not be reproduced or circulated without the prior written consent by BFI Infinity Inc., who expressly prohibits the distribution and transfer of this document to third parties for any reason. BFI Infinity Inc. shall not be liable for claims or lawsuits from any third parties arising from the use or distribution of this document. This publication is for distribution only under such circumstances as may be permitted by applicable law. This publication was prepared for information purposes only and should not be construed as an offer, a solicitation or a recommendation to buy, sell or engage in any venture, investment or financial product. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. Although every care has been taken in the preparation of the information included, BFI Infinity Inc. does not guarantee and cannot be held responsible for the accuracy of any statistic, statement or representation made. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results.

All information and opinions indicated are subject to change without notice.