Why do regional banks keep failing?

It’s March, which means it’s time to worry about the health of regional banks again. Last year, the anxiety was centered around regional banks with lots of exposure to the tech and crypto industries, sparking bank runs that led to the collapse of Signature Bank, Silicon Valley Bank, and, a bit later, First Republic. This year, the concerns have been centered on New York Community Bancorp (NYCB), which just got a billion-dollar infusion of capital from a group led by former Treasury Secretary Steve Mnuchin to help stabilize its balance sheet.

NYCB’s decline has been surprisingly rapid. A year ago, it was seen as so healthy that bank regulators allowed it to step in and acquire a significant portion of Signature Bank’s assets after it went under. And as late as January of this year, its stock price was up more than 50% from last March. But in late January, NYCB released an unexpectedly dismal quarterly earnings report, posting a $252 million loss, slashing its dividends, and setting aside a big chunk of reserves to cover potential future losses. That sent the bank’s stock price tumbling by 75% and raised the possibility that the bank might go under.

The Mnuchin group’s equity investment seems to have quelled investor concerns on that front, at least for the moment: NYCB’s stock price is up about 40% since March 4 (though it’s still down almost 60% on the year). But the problems that got NYCB in trouble have not gone away.

The most obvious of those is weakness in the commercial real-estate market, which has not really rebounded since the pandemic as many expected it might. The health of the commercial real estate market typically tracks the health of the economy as a whole, so that when the economy is doing well, as it has been for the past few years, commercial real estate does fine. But in part because of an increase in remote work, demand for office space from corporate tenants has dropped, making it harder for landlords to make their debt payments. And rising interest rates have limited their ability to refinance.

That’s raised concerns about regional banks generally. But the reality is that most regional banks have so far been able to weather the weakness in the commercial real estate market reasonably well. NYCB has not, and it hasn’t because it made a very simple mistake: it failed to diversify away risk.

The simplest risk, one that all regional banks face, is geographic: Regional banks tend to lend to businesses and landlords in their region. So by its nature, this is a risk that’s hard for regional banks to hedge away. And NYCB actually amplified this risk with its acquisition of Signature’s assets. The deal added billions more in commercial real estate loans in the New York area to its balance sheet, including many older loans that had been made in an economic and interest-rate environment very different from the current one. That made the bank even more vulnerable if the regional commercial real estate market weakened or did not rebound as hoped.

Beyond that, and more importantly, NYCB tied up a big chunk of its loan portfolio in one specific type of loan: mortgages to apartment complexes and, in particular, to rent-stabilized apartment complexes. You might think that would be fine, given that apartment rents in New York City are so high. But overconcentration in this market left the bank exposed to what economists call regulatory risk. That ended up biting it when New York passed a rule limiting rent increases for rent-stabilized apartments and making it harder for landlords to upgrade rent-stabilized units and then start renting them out at market rates. That’s made rent-stabilized apartments less valuable and increased the risk that landlords will default on their loans in the future.

NYCB’s problems are, then, mostly specific to it, which is why we haven’t seen much contagion from its woes to other regional banks. But its troubles do point to a fundamental dilemma that’s built into the regional-bank model: If we’re going to have these banks, we want them to lend to local businesses, and to fund local commercial real estate development. And they do: Roughly half of all commercial real estate debt is owned by local banks, and commercial real estate typically makes up a much higher percentage of smaller banks’ total loan portfolios than it does of big banks’ portfolios.

This means that regional banks are, by definition, more exposed to the risk of a downturn in their local markets. It also means that regional banks need to be especially vigilant about diversification when it comes to the types of loans they make, so that they don’t end up massively overweighted in one type of loan, and the kinds of customers they do business with. Indeed, what’s striking about Silicon Valley Bank’s collapse and NYCB’s near-collapse is that though their businesses were very different, their problems ultimately boiled down to a similar issue: overconcentration. The lesson, for both bank executives and bank regulators, seems pretty clear: Diversification isn’t an option. It’s a necessity.