Nine Ways a Stock Market Correction May Affect Community Banks

By Adam Mustafa and Leonard J. DeRoma

We are clearly in the face of a stock market ‘correction’ as investors struggle with problems in China, the threat of normalizing interest rates from the Federal Reserve, a strong dollar that is depressing oil and commodity prices, and other global economic issues. At one point in late August, the Dow Jones Industrial Average dropped a stunning 1,500 points. 

So what does this mean for community banks?  To answer this question, a correction must first be put into perspective.  Think of it as a symptom of a possible economic downturn driven by all of the aforementioned headwinds.  We don’t know what that may look like, but here are nine ways a stock market correction, increased volatility, and a change in the business cycle may have an impact:

The risk and reward characteristics of lending will change dramatically. 

Although it’s counterintuitive, banks with the right set of analytics will be able to take advantage of a great opportunity to make very attractive loans and increase their market share.  Bankers always forget the old saying that “the best loans are made in the worst of times.”  Easy to say, hard to execute – unless you have the right analytics.  We are working with all of our clients to quantify the risk and reward of their loans in a near real-time basis to help them determine when to get more aggressive or more conservative with making new loans. 

Acquisitive banks will see a shift in the power of their stock as currency. 

This may affect banks very differently.  Those banks that were previously trading at a premium may lose purchasing power, and those banks that were trading at or around book value will no longer be at such a disadvantage. 

Look for sellers to begin rushing for the door. 

There are a number of banks that have flirted with the idea of selling, but have decided against it in hopes of a larger price.  In the wake of a stock market decline, many of these institutions’ shareholders may be kicking themselves for not taking earlier offers.  This will be especially true for banks in low growth markets or slim NIM products, since the “go it alone” approach that relies on organic growth is already difficult and inefficient in the current environment.  This strategy will only become tougher in any kind of economic slowdown.  We suspect many of these banks will revisit previous bidders to see if these deals are still available.

Commercial real estate deals may come to a grinding halt.

The Fed’s zero interest rate policy may not have created inflation in the price of consumer goods, but it certainly has created inflation in the price of assets.  A stock market correction may be the market’s way of saying “enough.”  If that’s the case, CRE investors will no longer be willing to accept low cap rates on deals.  In turn, this could further slow lending activity, which has already become overly dependent on existing borrowers simply shopping around for a lower refinancing rate.  It may even slow refis since lower appraisals could squeeze borrowing capacity.

Going public may not be an option.

Some banks have considered going public as a way to attract capital more easily and give long-term shareholders an exit.  Volatile equity markets that have repriced downward may make this less likely.

Subordinated debt funding may get more expensive.

A number of banks have raised subordinated debt privately.  Expect the return demanded by bank investors to increase in volatile markets, especially if the perceived risk to loan portfolios is increasing.

Paying off grandfathered TruPS may become more problematic. 

Any decline in bank earnings due to economic slowdowns or increases in defaults may affect the dividend-paying ability of banks, reducing their capability to service or retire existing TruPS.

Investment portfolios may get a “reprieve.”

Although the Fed has jawboned about raising rates, they will find it difficult to do so on their current schedule.  Having painted themselves into a corner over the past seven years, the Fed will be loath to take the blame on an economic slowdown due to higher rates.  Any increase in rates will potentially strengthen the dollar, making exports more expensive, and negatively affecting GDP.  Banks’ fixed-rate investment and liquidity portfolios may not suffer from the predicted AOCI losses caused by a rising rate environment.  On the other hand, the spread differentials (yields over corresponding U.S. Treasury maturities) may rise to accommodate the increased return needed to support perceived corporate bond or agency/mortgage-backed paper.

Depositors may not rush out the door.

The flood of liquidity into banks from deposits has created an environment where banks have been able to achieve cheap funding.  The theory of the higher FDIC insurance limit attracting depositors as a safe haven from volatile investments will continue.

In summary, the stock market has just thrown a surprise speedbump that could symbolize the end of the post-crisis era, which featured a weak recovery, historically low rates, and asset inflation.  A new environment will create a playing field that will have different winners and losers.  Some banks will have the tools needed to cope with the expected rapid changes in the risk/reward profile and be able to profit from it.  Other banks will continue on the same road, but with many new potholes.