The rising yields on US Treasury bonds, a trend that began in late 2023, are creating significant challenges for regional banks. As borrowing costs climb, the financial resilience of smaller institutions is being tested, particularly in the face of mounting commercial real estate (CRE) risks.
Since late November, smaller bank stocks have dropped by approximately 8.2%, coinciding with an upward trend in the 10-year Treasury yield. This rise has exacerbated concerns about borrowers’ ability to manage their obligations, especially those who purchased office buildings prior to the pandemic when property values were significantly higher.
Steven Kelly, associate director of research at the Yale Program on Financial Stability, highlights the precarious balance for banks: “Rising long-term yields certainly leave the banking system more fragile in the short run, if more profitable in a base case economic scenario.”
The Federal Deposit Insurance Corporation (FDIC) underscores the impact of these trends. FDIC Chairman Martin Gruenberg noted in a December 12 speech that the surge in 10-year yields likely reversed much of the improvement in unrealized losses observed in banks’ portfolios during the third quarter. As of now, the 10-year Treasury yield hovers around 4.58%, intensifying the strain on lenders.
Higher borrowing benchmarks present a twofold challenge. Not only do they increase the cost of credit, but they also limit refinancing opportunities for CRE borrowers. According to Tomasz Piskorski, a finance and real estate professor at Columbia Business School, approximately 14% of the $3 trillion in US CRE loans are underwater. This figure jumps to a staggering 44% when focusing solely on office properties.
Smaller banks are particularly vulnerable to these defaults. These institutions often approved loans with lower down payments compared to their larger counterparts before interest rate hikes began in 2022. With office and multifamily property values plummeting, the buffer to absorb losses has diminished.
PNC Financial Services Group’s CEO, Bill Demchak, expressed ongoing concerns about the office market’s instability during a recent earnings call. PNC increased its reserves for potential loan losses, raising them from 8.7% at the end of 2023 to 13.3%.
However, there are glimmers of stability. Lower Federal Funds rates have reduced the cost of deposits, while steady deposit flows in the fourth quarter have alleviated fears of rapid withdrawals. This stability lessens the likelihood of forced sales of underwater bonds, a scenario reminiscent of the Silicon Valley Bank crisis.
Scott Hildenbrand, head of depository fixed income at Piper Sandler, observed that investors appear less concerned about unrealized losses given the current market dynamics. Similarly, Terry McEvoy, a bank analyst at Stephens Inc., noted that recent discussions with investors have revealed a diminished focus on these issues.
Despite these reassurances, experts caution against complacency. With borrowing benchmarks continuing to climb, even as the Federal Reserve reduces interest rates, banks find themselves in a precarious position. “Instead of escaping this area of bank fragility, we are moving toward an increasing area of bank fragility,” warns Piskorski.
The road ahead for regional banks is fraught with challenges. Balancing profitability against rising risks will require careful navigation of the evolving financial landscape. Policymakers and financial institutions must work together to mitigate these vulnerabilities and bolster the stability of the banking sector.