Putting Renewed Regional Bank Fears in Perspective

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Humans, quirky beings that we are, have a lot of lazy beliefs. Like this one: One of something is random, two is coincidence and three is a trend. So when two regional banks disclosed fraudulent loans to the same borrower this week, headlines chalked it up as the magical third thing to pair with last month’s Tricolor and First Brands bankruptcies. Only where those sparked fears in the private credit space, this third canary in the coalmine allegedly pointed to potential underwriting troubles across many regional banks. That sparked a selloff not just in the S&P 500 Regional Banks Index, but across banks globally as “contagion” fears surged.

To us, it looks like your classic scare story freak-out. These are idiosyncratic issues at two small US banks, highly unlikely to prove globally systemic risks.

The third canary chirped (err, stopped chirping?) Thursday, when regional lenders Zions Bancorp and Western Alliance disclosed some bad loans to Cantor Group, an investment fund that purchases commercial real estate mortgages. Zions disclosed it was writing off two loans totaling $60 million, claiming Cantor misrepresented the mortgages it used as collateral. Western Alliance, meanwhile, announced it launched legal proceedings over a $98 million bad loan to Cantor Group, also alleging collateral misrepresentations. This makes Cantor Group a third possible fraudulent borrower, following in the alleged footsteps of Tricolor and First Brands. We are using “allegedly” a lot here because nothing is proven, all this stuff takes time to determine and we have no special insights into whether these actions qualify as fraudulent or not. This is not, as it were, a commentary on the legal proceedings. Take that as a disclosure if you will.

But markets tend to react to such things quickly. They don’t tend to wait for legal processes to play out. And they often overreact in the ultra-short term. So these two banks’ troubles sparked a broader US regional bank selloff Thursday. The S&P 500 Regional Bank index fell -5.0% as investors worried small banks broadly may have lowered underwriting standards in order to boost sluggish loan growth.^[i] To us, this seems like a sentiment-induced overreaction. Even if there are some shady loans at risk of going bust, it is a stretch to extrapolate this to broad balance sheet trouble. Zions’ exposure to these bad loans amounts to 0.1% of its loan book.^[ii] Western Alliance’s exposure amounted to 0.17% of its loan portfolio.^[iii] The dollar amounts look big to the human eye, but as a percentage of these banks’ total business, they barely rate.

Still, a broader selloff is understandable from an emotional standpoint, in that it is standard for the entire sector to take a hit when some of its constituents show signs of trouble. We aren’t calling that a rational response, but it is understandable that the market might have a collective hiccup. We saw the same in early 2023 when Silicon Valley Bank and Signature Bank’s failures sparked broader regional banking concerns. The whole subsector took a hit and investors feared the proverbial next shoe to drop. But broad contagion never happened, and regional banks broadly recovered as investors fathomed that the issues really were company-specific. Today, it seems many are fighting the last war here.

We can’t rule out more banks reporting problems, but there is an easy way to see the industry isn’t currently in crisis: the Fed’s discount window.

The discount window has fallen out of the zeitgeist lately, but it is the Fed’s traditional means of lending to banks that need emergency help. Specifically, it is for banks that are solvent but having liquidity troubles and can’t find suitable funding on the open market. So they borrow from the Fed, in exchange for high-quality collateral, and pay the Fed’s discount rate. The Fed’s alphabet soup of emergency loan facilities during the global financial crisis and COVID lockdowns kind of made everyone forget about the discount window, but it remains banks’ primary lifeline. So if regional banks were broadly in trouble, we would expect to find discount window use jumping.

But it isn’t. Discount window use ticked up in September, coinciding with the Tricolor and First Brands implosions (although not necessarily caused by those implosions). In the week ending October 1, there were about $7.4 billion worth of discount window loans outstanding.^[iv] That fell to just over $5.6 billion the week ending October 8, a nearly $1.7 billion drop.^[v] In the latest report, for the week ending October 15, it ticked up just $4 million.^[vi] This all tells us regional banks broadly aren’t having trouble getting the liquidity they need. If there were an actual systemic crisis, we expect that these numbers would look a lot different.

Even less logical to us is the extrapolation to big overseas banks. This was the top headline across UK financial markets coverage Friday morning, with many blaming US regional bank concerns for a sharp selloff in UK Financials stocks. Not upstart challenger banks or regional subsidiaries like ye olde Silicon Valley Bank UK, but the largest UK-based global banks. We are talking banks on the list of globally systemically important financial institutions, or G-SIFIs, which are loaded with extra regulations and tough capital requirements. This suggests to us investors fear a re-run of Credit Suisse’s 2023 implosion without thinking through why that failure happened. Yes, Credit Suisse failed around the same time as Silicon Valley Bank. But that wasn’t because US regional banks were contagious, but because Credit Suisse had been limping from scandal to scandal for years, plagued with management problems and other company-specific issues. Its failure went down in about as orderly a manner as possible, and there was no contagion. One bad apple didn’t spoil the crate.

To us, it looks like the main “contagion” right now is fear, not actual, deep-rooted trouble. As we covered yesterday, corporate debt markets look quite healthy. And while private credit is one of several areas we are watching for potential trouble, that is less about its direct effect on bank balance sheets, which are pretty healthy overall, and more about how trouble could force selling in more liquid assets, like stocks or bonds, as investors scramble to cover losses. We don’t see signs that this is imminent, but we acknowledge the risk.

For now, we see the selloff and its global reach as signs sentiment remains skeptical. For all the talk of bubbles and euphoria, true euphoria means investors forget risk and see only sunlit uplands ahead. They reach for increasingly outlandish reasons to justify bullishness. We aren’t there yet. Instead, investors are perpetually looking for signs of trouble and reasons to justify the belief the party will end soon. That is a good indication this bull market’s proverbial wall of worry has plenty of bricks.

Hat Tip: Fisher Investments Research Analyst Michael Ackerman