The chaos that roiled regional banks this year could have been a lot worse. It is still likely to shake these lenders for some time to come.
When US regulators seized Silicon Valley Bank, Signature Bank, and First Republic between March and May, the fear was that panic would spread through the US banking system and take down other mid-sized institutions.
That hasn’t happened thus far. Only two more banks went down in 2023, and they were both tiny rural lenders in Kansas and Iowa, while deposit outflows and stock-price volatility stabilized for other institutions that had been under intense investor scrutiny.
Experts began arguing that the turmoil wasn’t a "crisis." Perhaps a "mini-crisis" at best. Just this week, two indexes that track the performance of regional banks returned to levels last reached before the fall of Silicon Valley Bank as investors cheered Federal Reserve predictions of three interest rate cuts in 2024.
But 2023 was still a seismic year for the industry. Not only did it produce the largest annual bank seizures as measured by assets ($550 billion), but it reshaped the industry — and will likely do so for years to come. That’s why the ruckus made it on the list of Yahoo Finance’s biggest stories of the year.
Perhaps one lasting lesson for regional banks that were caught flat-footed in 2023 is how quickly assumptions about US banking can get flipped upside down.
Before the turmoil, deposits were considered super-sticky funding sources since most customers were historically slow to move their money. Treasury bonds were also considered a super-safe place for banks to invest those funds.
Those assumptions were upended once the Fed embarked upon its most aggressive rate-raising campaign since the 1980s.
Read more: What the Fed rate-hike pause means for bank accounts, CDs, loans, and credit cards
Depositors began looking for higher yields elsewhere, starting a slow drain of deposits that would turn into a flood. The bonds that banks had purchased when deposits were flush also began to lose value, creating hundreds of billions in unrealized losses hiding in plain sight on balance sheets.
This all came to a head in early March when Silicon Valley Bank sold some of these bonds that had lost value, took a loss, and tried to raise new capital. The news spooked depositors, who through online accounts and mobile phones withdrew an eye-popping $42 billion in just one day.
Customers began to do the same at other banks, challenging the assumption that deposits would always be a stable, sticky form of funding. Within the next month, another $390 billion in deposits left US banks, on top of $600 billion already drained from the banking system before March.
Regulators helped stabilize things by guaranteeing to cover uninsured deposits at Silicon Valley Bank and Signature Bank while finding a buyer (JPMorgan Chase) willing to assume deposits and assets from First Republic.
But that didn’t alter a fundamental shift in the business model for many regional banks.
They began paying a lot more for deposits so they could keep their funding intact, a change that cut into their profits. These mid-sized banks rely heavily on the spread they earn between loans and deposits, while bigger national institutions like JPMorgan and Bank of America can lean on other revenue sources.
"The 2023 situation was another manifestation, another endorsement of the big-bank business model, and really, it's sort of damning for the regional banks with a niche business model," Steven Kelly, associate director of research at the Yale Program for Financial Stability, told Yahoo Finance.
Some, as a result, are already shedding assets and certain businesses. Others are expected to merge so they can better compete with larger rivals.
Margins for regional banks are expected to continue dropping in 2024 since rates will remain elevated even if the Fed starts cutting.
"I think you’ll continue to see deposit costs go up for two to three quarters" after the Fed declares that it is done raising rates, Harris Simmons, the CEO of regional lender Zions (ZION), said last week at a conference in New York City.
Some mid-sized banks also face the prospect of higher capital requirements imposed by regulators, which will also act as a damper on profits.
And if the US economy enters a recession, which some still think is possible, that presents other problems for these banks if borrowers run into more trouble and can’t pay back their loans.
"The part of the cycle that we're not through yet is a slowing economy," said Wedbush bank analyst David Chiaverini, who anticipates a mild recession in 2024.
A specific worry is that commercial real estate could start producing major losses for regional banks, which are big financiers to office buildings across the US that emptied out during the pandemic and have not yet recovered pre-pandemic occupancy rates.
"It is going to take some time for regional banks to repair their balance sheets," said Apollo's chief economist Torsten Slok in a recent note (Disclosure: Apollo is the parent company of Yahoo Inc.).
Read Yahoo Finance’s countdown of the biggest stories of 2023:
David Hollerith is a senior reporter for Yahoo Finance covering banking and crypto.
Click here for in-depth analysis of the latest stock market news and events moving stock prices.
Read the latest financial and business news from Yahoo Finance