(September 15, 2023) - Seyfarth Shaw LLP attorneys David Bizar and William J. Hanlon discuss best practices for commercial customers as large and midsize banks continue to face economic and regulatory headwinds.
Silicon Valley Bank ("SVB") was closed by the FDIC and its primary prudential regulator on March 10, 2023, followed by Signature Bank two days later on March 12, 2023 and First Republic Bank, on May 1, 2023.1 These were the second through fourth largest bank failures in U.S. history, First Republic Bank with $212 billion of assets, SVB with $209 billion, and Signature Bank with $110 billion.2
Upon the first to fall, we immediately urged increased diligence concerning the safety and quality of banks and banking relationships.3 We advised commercial bank customers to review and memorialize their decisions regarding the safety of their bank deposit funds that exceed the standard FDIC insurance limits of $250,000 per depositor, per insured bank, for each account ownership category, consistent with their fiduciary duties.
Discussing and deciding this issue, so long as it is performed with due care and in good faith, entitles fiduciaries to the shelter of the "business judgment rule," which is intended to keep their decisions from being second-guessed by a court. We also advised holders and potential drawers of letters of credit issued by the failed banks to individually review their situations concerning whether the letters would need to be, or should be, replaced or not.
In the ensuing six months, while there have not been any more large bank failures and the overall economy and economic outlooks have improved, heightened diligence nonetheless remains warranted for commercial bank customers.
Recently, the largest banks have written off approximately $5 billion of credit defaults (roughly double the same period last year) and rating agencies have downgraded several mid-size bank ratings. Rising interest rates and decreased demand for office space are further ratcheting up the pressure on commercial real estate. Meanwhile, the low FDIC insurance coverage limits have not changed.
According to the Financial Times, the nation's largest banks have written off a combined $5 billion worth of loans in Q2 of this year as borrowers experience the double whammy of inflation and higher interest rates.4 The big banks are setting aside billions more to cover more loans that could potentially go bad. Credit card debt is the primary source, followed by office loans.
Reuters states that "[d]eposits at the U.S. banks have stabilized after a tumultuous period in March, when two of the largest bank failures since the 2008 financial crisis spurred consumers to seek safety by moving their money to large institutions."5
Since then, as interest rates have continued to rise deposits at two of the largest U.S. banks have declined by 6 and 7% due to consumer deposit outflows on consumer spending and customer migration to higher yielding alternatives, such as certificates of deposit.6 "While higher rates are expected to boost earnings for larger banks, those gains will be tempered by moderating appetite for loans at higher deposit costs ... ."7
Deloitte notes that while economic growth has slowed to a crawl in 2023, it has not declined enough to merit the label of a recession.8 It predicts a 60% likelihood that the economy will nonetheless slow substantially in the second half of 2023, as lending standards are tightening and business investment remains soft.
But it also recognizes a 40% chance that either inflation will come back and settle in at about 6%, further damaging the U.S. economy, and a 20% chance of a recession in which "the already-weak economy contracts a substantial 2.4% by the middle of 2024" while "the unemployment rate rises to 5.5%, which alleviates some — but not all — of the pressure on the job market."9
JPMorgan opines that "a recission appears off the table this year" but regional banks are experiencing slower loan growth due to headwinds to economic activity and commercial real estate challenges are mounting.
The three major rating agencies have, in examining the headwinds and challenges that banks are facing recently downgraded several bank ratings.
According to Reuters:
- S&P cut its ratings on two mid-sized banks based on funding risks and higher reliance on brokered deposits, while three others were downgraded on large deposit outflows and prevailing higher interest rates.
- Moody's lowered ratings on 10 U.S. banks and placed six on review for potential downgrades.
- Fitch, the last of the three chief rating agencies, projected that several U.S. banks could see downgrades if the sector's "operating environment" deteriorates further.10
As a rule, banks have not been immune from failure. There have been a total of 565 bank failures from 2001 to 2023.11 The U.S. Government Accountability Office ("GAO") posits presently that particularly banks "that loaned money for commercial real estate ventures may be feeling the pinch as many office and business spaces continue to sit vacant in the wake of COVID-19."12
The GAO "found that failures of small and medium-sized banks [during 2008-2011] were largely associated with high concentrations of commercial real estate loans" and that "when these banks were exposed to the sustained real estate and economic downturn that began in 2007, credit losses on commercial real estate loans drove them to fail."13 "[T]his combination of aggressive growth strategies and weak risk-management practices [was] similar to what [the GAO] found in the March Silicon Valley Bank and Signature Bank failures."14
Commercial real estate loans may prove problematic for small community banks, but industry giant CBRE does not view them as a threat to the banking system: "Office loan losses, while challenging for banks, are unlikely to destabilize the broader financial system since office loans held by banks make up only 1.5% of assets in the banking system. The banking sector's projected losses on all CRE loans account for only 3% of banks' equity capital and disclosed reserves.
We do not see this as comparable to the GFC [global financial crisis of 2007-2011]".15 Still, the GAO cautions that "some businesses continue to offer employees a choice on whether to return to their offices full time or under some hybrid work arrangements ... [which] could continue to affect demand for office space and commercial real estate loan performance, creating ongoing uncertainty about the risks."16
In late July 2023 US bank regulators advanced proposals directed at a perceived undercapitalization of the nation's largest banks imposed by the Dodd-Frank Act.17 The new rules proposed by the Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation would increase the level of capital that Large Banks with $100 billion or more in total consolidated assets would be required to hold.
The rules, collectively known as the Basel III endgame, if finalized after going through the standard notice-and-comment rulemaking process which has been noticed to end on November 30, 2023, would be phased-in starting July 1, 2025, until June 30, 2028.18
According to CNN, US banks deemed systemically important globally — or, colloquially, "too big to fail" — would have to set aside an additional 19% of capital on average, according to the proposal.19 Banks with more than $250 billion in assets that aren't considered systemically important would see a 10% increase in the capital they're required to hold.20 Banks with asset levels between $100 billion and $250 billion ... would see a 5% increase.21
The Wall Street Journal reports that "With the commercial-real estate market now in meltdown, those trillions of dollars in loans and investments are a looming threat for the banking industry — and potentially the broader economy. Bank exposure is even bigger than commonly reported. The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses."22
Our takeaway for commercial bank customers is that while the overall economy is showing signs of resilience, the banking landscape remains fraught with uncertainty, which calls for continuing vigilance. The safety and quality of banks and banking relationships should remain a regular agenda item. Whether directors, specifically, have satisfied their fiduciary duties is a fact-bound determination.
The Delaware courts, for example, will generally consider factors such as how much time the directors had to review the information, what information they reviewed, how critically they reviewed that information, and whether they sought expert financial or legal advice.
Delaware law typically applies a "gross negligence" standard to determine whether directors have satisfied their duty of care. Whosever law applies, fiduciaries should continue to stay abreast of how economic developments may impact their deposits, letters of credit, loans, and banking relationships. The best practice is to thoroughly review and memorialize these inquiries to evidence that the issues were discussed, and that the board or other inquiring body satisfied its fiduciary duties and made a rational business decision.
Originally published by Thomson Reuters - Westlaw Today.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.