What’s really behind small banks’ struggles?

Ratings agency S&P Global downgraded five U.S. regional banks (including KeyCorp, which is the 20^th largest U.S. bank) on Monday, and put two others on notice for a potential downgrade. That followed a similar action by Moody’s two weeks ago, when it downgraded 10 regional banks and put 6 others on notice. Together, the downgrades make clear that the concerns about midsize and smaller banks that emerged this spring (when Silicon Valley Bank, Signature Bank, and First Republic failed) have not gone away. 

More to the point, these downgrades make clear that the problems regional banks face are structural rather than specific to individual institutions. The bank failures we saw this spring could be explained as the product of reckless financial decisions, or idiosyncratic issues: Signature and SVB both relied heavily on uninsured deposits from a concentrated group of industries, making them vulnerable to bank runs, and had not done a good job of hedging their interest-rate risk. 

The banks Moody’s and S&P have downgraded, by contrast, are largely just ordinary midsize-to-small banks doing business in an ordinary way, rather than institutions that have made obviously reckless bets. There may be specific issues that make them mildly more risky than similar-size competitors, but the basic problem they face is the business they’re in.

What the downgrades really tell us, then, is that ordinary banking, at least for banks that are not too big to fail, has become a much tougher business over the past two years. That’s not, for the most part, because banks are seeing lots of defaults on the loans they’ve made. Because the job market has stayed strong and the economy has been chugging along, delinquency rates on mortgages and auto loans have stayed low. And while the threat of defaults in the weak commercial-real-estate market continues to loom over the banking industry as a whole, so far those losses have been relatively small.

Instead, the problems are really the result of the big spike in interest rates over the past two years. That’s had two big consequences for these banks. First, it’s meant that the value of the assets on their balance sheets has dropped, because the value of old loans and bonds falls when interest rates rise. (If you can buy a 10-year bond with an interest rate of 4.2% today, you’ll only buy a 10-year bond with an interest rate of 1.45% at a serious discount.) 

It’s not that those loans are bad: They’re continuing to generate income for the banks, and if they hold them to maturity, they’ll get all their money back. But they’re worth a lot less than banks paid for them. At the end of 2022, the FDIC reported, banks were sitting on $620 billion in unrealized losses on their balance sheets.

The second problem is that higher interest rates has raised the cost of doing business for banks. Historically, rising interest rates were a good thing for banks: They could charge a higher rate for new loans while still paying their depositors relatively low interest rates. So their profit margins typically widened when interest rates rose. 

This model was predicated on the idea that bank depositors were generally loyal customers (if only out of inertia and a desire to avoid the hassle of changing banks), and that bank deposits were therefore sticky. But that idea is now outdated, thanks to technological and behavioral changes that have made it easier for customers to move from bank to bank in search of higher interest rates on their deposits.

Moving deposits, after all, used to be—to use the technical term—a pain in the ass. So most depositors, especially smaller ones, weren’t going to switch banks in the pursuit of a couple of extra percentage points on their deposits. Today, by contrast, you can move your money pretty much at the touch of a button, without ever leaving your desk. And there are plenty of reliable financial institutions offering high interest rates for your deposits. 

The result is that banks now face more competition for their customers. The biggest banks can, to some degree, avoid this, since their too-big-to-fail status means that depositors see them as extra-reliable. (During the first quarter of this year, for instance, as SVB was melting down, JPMorgan Chase grew deposits by $37 billion.) But regional banks don’t benefit from that. So some have seen depositor flight: Comerica, one of the banks S&P downgraded, saw its average deposits drop by $14 billion from the second quarter of 2022 to the second quarter of 2023. 

These banks are also having to pay higher rates to keep their customers: Over the past five quarters, the portion of assets in non-interest-bearing accounts has fallen by 23%, and the portion of assets in certificates of deposit (which pay higher interest rates) has doubled. That raises their funding costs and compresses their profit margins on new loans, at a time when the value of a lot of their older loans is dropping.

The basic model of commercial banking—borrow short while lending long—has always had an inherent shakiness to it. (On the most banal level, if all, or even most, of a bank’s depositors ask for their money back, the bank obviously can’t give it to them.) That model is easy to sustain when bank deposits are sticky: As the old joke goes, you pay 3% on deposits, lend money at 6%, and get to the golf course by 3 o’clock. It becomes trickier when depositors can, and will, move their money around with ease. Now, instead of paying 3% on deposits, you have to pay 4% or even more.

That doesn’t mean that a new banking crisis is imminent. But the Moody’s and S&P downgrades are a sign of the structural problems that regional banks are facing in this new era, problems that our current regulatory and deposit-insurance systems haven’t really adapted to yet. The banks that have been downgraded have just been doing business as usual. But business as usual isn’t usual anymore.