The wave of rolling crises the world experienced 15 years ago amid what would come to be known as the global financial crisis stands in marked contrast to that being experienced today in U.S. banking.

We reflect on the shotgun weddings of JP Morgan Chase and Bear Stearns in March of 2008 and Bank of America and Merrill Lynch that September, the same month Lehman Brothers was left at the alter to fail and the U.S. government nationalized the housing finance giants Fannie Mae and Freddie Mac.

In a month that will be remembered as one of the darkest in U.S. economic history, Washington Mutual succumbed to a bank run in what to this day stands as the largest ever U.S. bank failure. Stocks plummeted as our U.S. banking system teetered on the verge of collapse, staggered by a loss of confidence spawned by bad mortgages made and securitized here, but which metastasized globally.

A total of 165 banks would eventually fail as the U.S. economy endured its most protracted economic downturn since the Great Depression. Thanks to unprecedented actions instituted by the U.S. government and Federal Reserve, asset purchase plans and liquidity programs helped cleanse the financial system of bad assets while providing banks the emergency funding they needed.

Lessons Learned

An enduring legacy of the global financial crisis is bank-reform legislation that mandated stronger industry oversight by the Fed and ended the practice of bank proprietary trading—the Volcker Rule. As importantly, banks that survived the near-death experience of those harrowing times became more responsible lenders. Subprime mortgages became less common as banks eschewed risk and operated under stricter capital guidelines; infamously opaque collateralized debt obligations nearly disappeared as bank balance sheets became more transparent.

As the Fed attempted to jump-start an economy laid low by the financial crisis, zero-interest-rate policy, and quantitative easing failed to stimulate a large jump in lending. Once bitten, twice shy, banks operated more conservatively as they made better loans and rebuilt capital, or shareholders’ equity. Stringent loan underwriting standards over the past 15 years have contributed to improved loan quality—lower loan-loss rates—and profitability, which in turn have promoted sturdier bank balance sheets and higher capital ratios.

Total loans and leases of all Federal Deposit Insurance Corp.-insured banks averaged $12.1 trillion in the fourth quarter of 2022, and of these, just one-third of 1% were written off. Net charge-offs as a percent of loans have not only declined significantly since the global financial crisis, but they also compare favorably to the average of historical data since 2000. With loans and leases accounting for over half of bank assets, we find this evidence of improved loan quality reassuring amid recent concerns about the industry’s health.

New Challenges

Responding to generationally high inflation that has proven to be more enduring than first thought, the Fed has raised short-term interest rates aggressively over the past year. In related fashion, bond prices fell, and fixed-income investors endured unusually negative returns, the worst in over 150 years. For most investors, 2022 was a year to nurse their wounds and move on.

For Silicon Valley Bank, its bond losses ultimately proved fatal. On the liability side of its balance sheet, SVB possessed an unusual base of depositors—90% exceeded the FDIC’s $250,000 insured deposit limit—concentrated in venture capital and development-stage companies that even in the best of times are users of cash.

This balance sheet peculiarity alone might not have doomed SVB if over half its assets were not invested in longer-maturity bonds, the market value of which were materially reduced by the rise in interest rates. SVB’s customers got nervous as they realized the bank’s capital was impaired, and what ensued was a classic bank run.

Pushed into FDIC receivership after failing to raise capital, SVB and its $212 billion mismanaged balance sheet became the nation’s second largest bank failure. As Fed Chair Jerome Powell recently observed, “This was a bank that was an outlier in terms of both its percentage of uninsured deposits and in terms of its holdings of duration risk.” In fact, most banks had nowhere near as much capital exposed to the risk of rising interest rates.

Following SVB’s demise, Signature Bancorp also went into FDIC receivership. Like SVB, it banked customers with deposits predominately in excess of FDIC deposit limits, but with the added risk factor of having a payments network catering to cryptocurrency customers. To discourage further bank runs, the U.S. government has announced that all SVB and Signature Bank depositors will recover their funds, even those with deposits exceeding the FDIC limit.

In the wake of these notable bank failures, the Fed also has reprised its role as lender of last resort, this time by offering banks experiencing deposit volatility a lending facility that allows them to pledge bond collateral at 100% of par value. While its recently created Bank Term Funding Program has been lightly tapped so far, the Fed’s traditional discount window has seen a notable uptick in use.

We believe that banks with traditional business models—a diversified deposit base used to fund a variety of performing loans and a much smaller proportion of marketable securities—will manage through the current challenges and emerge with adequate levels of capital. With Fed credit facilities available to provide liquidity to the banks as needed, we do not foresee systemic risk to the banking system. However, we do anticipate lower than previously anticipated bank profitability in the wake of recent turbulence.

Earnings Risk

Turmoil in the banking industry comes at a time when loan growth had begun to pick up and with net interest margins benefiting from higher interest rates. For this economic cycle to date, most bank balance sheets have been asset sensitive from an earnings perspective. In other words, bank assets were accruing more income from rising rates than the additional interest expense on the liabilities used to fund them.

Now, banks are having to pay higher rates on certificates of deposits and passbook savings to retain deposits more prone to flight amid higher-interest-rate alternatives for depositors’ cash. As well, banks’ cost of capital is increasing because loans now comprise a higher percentage of their low-cost deposits, leaving banks to finance a growing percentage of new loans with higher-cost borrowings from other banks or the bond market.

Higher interest expense is also likely to pressure earnings in an environment of heightened caution, one in which bank loan officer surveys indicate they are less willing to make higher-yielding loans and more likely to hold incremental assets in cash and short-term securities.

Another risk is that regional banks may encounter credit issues given their greater exposure to commercial real estate loans. While banks smaller than the top 25 largest by assets account for two-thirds of all real estate lending, only 15% of such loans are to office building borrowers struggling with low occupancy rates. Other real estate verticals like health care, multifamily, and industrial remain fundamentally healthy.

We believe office building loan exposures are well known, and while they do not pose systemic risk, they could negatively impact bank earnings if borrowers default.

Finally, additional fees and regulation are possible. The FDIC could increase the levy it imposes on bank deposits to replenish its insurance fund depleted by recent bank failures. As well, regulators might impose new balance sheet constraints to limit mismatches in asset-liability duration, potentially reducing the earnings potential of bank assets.

We believe that profit projections for the broader market remain too high for 2023. As a top-three contributor to earnings growth investors expect the S&P 500 to deliver this year, financials may disappoint given the banks’ meaningful representation within the sector. Even more importantly, banking is the lifeblood of the economy. If lenders retrench to the extent that a credit crunch ensues, this will precipitate slower economic growth and heighten the risk of recession.

Acknowledging these headwinds, we have become more defensive in our equity sector allocation in client accounts, underweighting the financials sector, and have reduced our regional bank exposure.

Shawn Narancich, a chartered financial analyst, is executive vice president of equity research and portfolio management with Ferguson Wellman Capital Management.