One year later: Bank failures and lessons learned

The world feels a lot different than it did a year ago.

Last week back in March 2023, a series of bank failures shook confidence in the banking system. Many feared a recession was inevitable. Some predicted a stock market crash akin to the Global Financial Crisis.

Yet the policy response was swift and meaningful. In a short time, recession obsession faded as the economy proved to be resilient, and stocks marched on to new all-time highs.

But that doesn’t mean the landscape is without scars: more than three-quarters of U.S. regional banks’ share prices are lower than before the stress began. And while investors no longer fear bank runs, encumbered commercial real estate (CRE) remains a concern. Bank profitability is still under pressure amid high rates, emergency-era lending is coming to a close, and regulation is just getting started.

This week’s Top Market Takeaways unpacks what’s changed over the last year, what’s stayed the same and what could be ahead. Through risks and market swings, we remain constructive on the path ahead.

What’s changed: There’s been a lot of good

• The economy has powered on. When things felt especially bad, Street expectations for a U.S. recession surged as high as 75%. While we were also concerned, we didn’t think the episode would be a repeat of the GFC: Policymakers had the tools needed to navigate stress, the banking system as a whole looked sound, the economy was coming from a place of strength, and the magnitude and potential for contagion seemed smaller. This proved true. From there, consumers showed resilience, fiscal stimulus provided powerful support, and an influx of new workers helped swiftly rebalance the labor market. Today, consensus recession probabilities are back down to about 30%, and economists have been revising their U.S. growth estimates even higher.
• Inflation progress has been real (albeit bumpy), and cuts are coming for good reason. As recession fears raged, markets quickly priced out all Federal Reserve hikes and even saw three cuts in 2023 to stem the foreseen bleeding—despite core inflation still running at a near 6% annual clip. Yet strength took root, and the Fed actually hiked another three times.
  
  Cuts now seem on the cards in 2024—but for very different reasons. Last week’s U.S. CPI print for February showed that core inflation is at a less-hot 3.8% year-over-year, the coolest it’s been in almost three years. That said, we’d be remiss not to acknowledge that this CPI print, and the one on producer prices on Thursday (PPI), were both hotter than expected and too heady for the Fed’s liking. That comes after an upside surprise in Europe earlier this month, too. 

This has caused some nervousness on how disinflation progresses from here: government bond yields moved around +20 basis points higher in both the U.S. and Europe last week. We agree that the resilience of the economy and the stickiness of inflation have made rate cuts less urgent than they seemed at the start of the year, but we consider the recent data more of a speed bump than a roadblock. Considering tailwinds across the labor market, shelter and supply chains, we continue to see inflation progress as on track toward the 2% targets over the next year.

• Stocks are making all-time highs, but not everyone is joining in. In the end, last year’s bank stress only prompted the S&P 500 to sell off -8%, and the full year still finished a staggering +26% higher. So far this year, the S&P 500 has made 17 new all-time highs, and it’s not just big tech. The equal-weight index likewise last week notched its first record in two years, and several European stock markets are hitting their own highs. However, areas of the market that are more in the bank-stress-crosshairs are still showing weakness. U.S. regional banks remain an outlier, and even that is skewed by the most at-risk lenders. Those with more CRE exposure have fared the worst, while some of those with less exposure have actually posted gains over the last year.

What’s stayed the same: There are still risks

• Regional banks aren’t out of the woods. Some of the sorest spots within U.S. regional banks had ultra-concentrated customer bases, particularly in once high-flying parts of the market that burned through cash and relied on easy money, such as crypto, venture capital and startups. Moreover, with interest rates higher, all banks have been under pressure to up the ante on deposits (i.e., pay more) to keep savers in the door—if they can’t hack it, they risk their customers yanking their business and going elsewhere. We learned the hard lesson of how that and the worst-case scenario of deposit flight can put pressure on banks’ balance sheets, especially regionals that aren’t as well capitalized or diversified. Loans made when rates were low quickly became less valuable as the Fed hiked, and thus couldn’t be sold as easily when times turned hard.
  
  Today, a number of regional banks still look undercapitalized when we account for unrealized losses on their balance sheets. Tension may remain until rates start to fall meaningfully (increasing the value of existing loans) and banks rebuild their capital buffers. We don’t see an imminent catalyst bringing about the collapse of another bank, but profitability pressure may remain for some time yet.
• Commercial real estate is a source of vulnerability. Compared to big banks, small U.S. banks hold 4.4 times more exposure to U.S. CRE loans than their larger peers. Within that cohort of small banks, CRE loans make up almost 30% of their assets, compared with only 6.5% at big banks. So far, we’ve only seen a minimal pickup in delinquencies, but transparency in the space is limited, and a significant percentage of CRE loans will require refinancing in the coming years (and at much higher rates when they were first taken out). If too many loans go bad quickly, this could create a bigger problem for those small banks that are under-reserved.
  
  Understanding industry trends are important for highlighting areas of stress. Here, the office sector—wracked by the widespread adoption of hybrid work—continues to face its own unique set of challenges, while other areas still look solid (think industrial assets, logistics properties, manufacturing facilities and warehouses). We don’t think stress and potential losses within office CRE are likely to destabilize the broader system. In all, it represents just 0.35% of U.S. GDP. 

• Credit is still tighter, but stabilizing. Many worried that the spate of banking stress would harm growth, as tighter lending standards and profitability challenges led banks to reduce available financing and raise costs for small and medium-sized businesses. To be sure, lending growth did slow. Yet as we mentioned, the U.S. economy defied expectations, and loan growth is now stabilizing again.

Tighter credit conditions are still a risk we’re monitoring. But while interest costs are higher and now take up a larger share of corporate and consumer income compared to the past, balance sheets and cash flows across both the U.S. and euro area remain healthy overall. Some interest-rate-sensitive sectors, such as housing and manufacturing, are even seeing some signs of green shoots.

What could be ahead: Searching for long-term solutions

As the drama unfolded, swift and coordinated action by the FDIC, Fed, Treasury and even a consortium of U.S. banks did much to offer liquidity, reassure bank depositors and ensure calm. As part of that, the Fed created a historic Bank Term Funding Program to provide emergency support. Now, in a sign of more stable times, this program ended (as expected) this week. As we now move beyond the band-aid fixes, this poses the question: What is the long-term solution for banking sector stability?

Regulators are working to bolster the health of the banking system. The Fed and others are tightening their grips on capital requirements for banks through the likes of Basel III Endgame and other measures that increase the need for short-term liquidity. This signals that steps are being made in the right direction, but the balance between security and industry concerns is still a work in progress. Chair Powell signaled recently that the central bank is even considering a “broad” overhaul of its initial capital requirement proposals.

That said, it’s worth noting one lesson from the latest Q4 earnings season: The biggest, systemically important banks still signposted strong capitalization. This is a good sign that large banks have a firm buffer ahead of potential regulatory changes or even the risk of an economic slowdown.

Finding opportunity through the risks

In the end, staying invested prevailed over the last year. It’s also worth noting that last week marked the four-year anniversary of the start of the COVID drawdown, when the S&P 500 fell almost 10% in a single day. As an unexpected pandemic gripped the globe, it would have felt really tempting to hit “sell”. But if you’d held on to your investment, it would have grown over +120% from that day until now.

Time makes a lot of difference. As we look forward and survey the current landscape, we see a host of attractive investment choices across asset classes. We believe stocks will continue to make new highs, and bonds are now in a different regime. And as much as tighter credit and stress are risks, they can also create opportunity for investors. For instance, private lenders can collect a premium for providing capital, and stress-focused managers can take advantage of mispriced assets and loans in areas such as commercial real estate.

As during the past year, investors should rely on steady hands to guide their long-term portfolios, and should focus on investments that can help diversify and grow their wealth over time. Your J.P. Morgan team is here to discuss what portfolio options work best for you and your family.