Regional Banks Face Headache From Rising Treasury Yields

(Bloomberg) — US Treasury yields have trended up since late last year, and commercial real estate distress risk is straining regional banks’ balance sheets again.

Stocks are already reacting to the higher borrowing costs. Smaller bank shares have fallen about 8.2% since late November after the 10-year Treasury yield began trending up. The risk of default by borrowers who bought office buildings before the pandemic sent values plummeting also increases when the cost of credit rises.

“Rising long-term yields certainly leave the banking system more fragile in the short run, if more profitable in a base case economic scenario,” said Steven Kelly, associate director of research at the Yale Program on Financial Stability.

A surge in 10-year yields last year likely reversed most of the decline in unrealized losses on banks’ available-for-sale and held-to-maturity securities in the third quarter, Federal Deposit Insurance Corp. Chairman Martin Gruenberg said in a Dec. 12 speech. Even after this past week’s rally after better-than-expected inflation data, the benchmark has since risen about 0.3 percentage points to around 4.58%, adding to the pain for lenders.

If borrowing benchmarks remain high, regional banks risk higher losses on commercial real estate because borrowers will struggle to refinance, said Tomasz Piskorski, a finance and real estate professor at Columbia Business School. He and fellow researchers estimate about 14% of the $3 trillion of US CRE loans are underwater, rising to 44% for offices.

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Smaller lenders are more vulnerable to CRE defaults after demanding lower down payments from borrowers than their larger counterparts in the run up to the interest-rate hikes that began in 2022. Now that office and multifamily values have crashed, the lenders have less of a buffer before taking losses.

The office market has yet to stabilize “which is why we remain concerned and remain well-reserved,” PNC Financial Service Group Chief Executive Officer Bill Demchak said on an earnings call this week. The bank increased the reserves it set aside to cover soured office loans to 13.3%, up from 8.7% at the end of 2023, although it’s a small proportion of their overall book.

On the plus side, the declining cost of deposits, thanks to lower Federal Funds rates, helps stability. Steady deposit flows in the fourth quarter suggest that the odds are low that they could quickly be moved to other banks, reducing the risk that lenders have to sell underwater bonds. Duration risk is also reducing as the securities move closer to maturity.

For now, “investors are a little less concerned about the unrealized losses, because it doesn’t look like there’s going to be forced sales like there was with Silicon Valley Bank,” said Scott Hildenbrand, head of depository fixed income at Piper Sandler.

Terry McEvoy, a bank analyst at Stephens Inc., concurs. The firm has met at least 30 bank investors in recent days and it was not a major area of discussion or concern, he said. The incoming Trump administration may also boost bank margins through deregulation, said Piskorski at Columbia Business School.

Still, with borrowing benchmarks trending up even as the Fed cuts interest rates, “we are entering into a very precarious position” and “instead of escaping this area of bank fragility, we are moving toward an increasing area of bank fragility,” Piskorski said.

–With assistance from Greg Ritchie and Rheaa Rao.

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