Consolidate or Fail: Regional Banks & Community Banks

Ryan Gosha
12 min readMar 12, 2024

Scott Rechler, CEO of RXR Realty, and a Board Member of the Federal Reserve Bank of New York made an outlandish claim that 500 small banks will either fail or be taken over within the next couple of years, due to problems within the Commercial Real Estate space.

The United States has 4500 banks. It's overbanked, clearly. However, to predict that 500 of these 4500 (11%) institutions will merge or fail before 2026 is hard to fathom and accept. Five Hundred is a lot.

Scott is either a very informed person or an overly excited doomsayer. To his credit, if there is anyone qualified enough to comment on the issue, it's him. He oversees a company that operates in the real estate space and he also oversees banks and monetary policy via his board seat on the Fed of NY. He has his eyes on two data sets and understands both from two different perspectives. That places him in a position that is second to none.

The banking sector as a whole is not yet due for another crisis. Big banks are in great shape. Small banks, however, are in a precarious situation where their future depends entirely on whether they can consolidate successfully or not, as they face the Commercial Real Estate “slow-moving train wreck”, as he calls it.

Commercial Real Estate — Slow-Moving Train Wreck

Regional Banks and some community banks have high exposure to commercial real estate (CRE). This makes up about 27% of assets on their balance sheets. In contrast, big banks only have 6% exposure. The beloved work-from-home habit picked during the pandemic does not seem to be going away anytime soon, even after corporations have tried to force employees back into offices. This has hit commercial properties very hard, with high vacancy rates. Some tenants are running down the leases and do not intend to renew, or at least intend to renew the lease for a smaller space. Though some optimists, high on delirium think that the drop in vacancies has hit a bottom, the reality is that we don't know if we have hit a bottom.

CRE is an extremely leveraged corner of the real estate space. Property values are tightly linked to rental cashflows & yields. Declines in such have resulted in massive declines in property values. Regional banks that extended loans to CRE firms are faced with loans that are increasingly turning out to be non-performing. The value of the collateral asset backing the loan (the property) has also gone down, blowing past the Loan-to-Value (LTV) buffer and further sinking below the value of the original loan. Any repossession given a default means loss realization, and good luck trying to dispose of that property in this market in a fire sale (typical when banks need liquidity).

This CRE tsunami is what scares Rechler. It does not happen dramatically. It rather metastasizes slowly and gradually. From his perspective, there is nothing in the way to stop this train. The only saving grace is mergers and consolidations. Failure to consolidate will result in some bank failures.

The CRE train wreck is not the only problem faced by small banks and credit unions. It’s the most prominent now, in terms of media exposure. There are other problems too.

“Higher for Longer Risk” — Losses on Investment Securities

This was the 2023 problem that contributed to the failure of SVB. Banks buy Treasury Securities. These are safe in terms of credit risk (The Teasury will always pay on time) but they still have exposure to interest rate risk. Banks loaded up balance sheets with TBs when interest rates were low. Then interest rates went up. The value of interest-sensitive assets they bought during the low-rate environment came tumbling down like the walls of Jericho.

If the banks made losses, how come they haven't failed? Because the losses are not real, yet. It's unrealized losses. They only become real when you sell. It's kinda like the “one bitcoin is one bitcoin” mantra that Hodlers peddle. If you have one bitcoin, it remains one bitcoin regardless of what the market says it is when measured in US dollars (fiat currency). The same logic applies to Treasury Notes. If you paid $1.95 bn four years ago for T-Notes with a face value of $2 bn maturing in year 5, or 7 or year 10, whichever is the case, you still get the $2 bn at maturity.

Banks have simply delayed realizing the losses. They are holding and waiting for rates to come down. They are sitting on a huge pile of unrealized losses.

The losses only become real when you realize them. Time is the master. If you can hold on until rates go down, you are okay. If you need to sell between now and rates going down, you are not okay. How long can they hold? Well, it's like a game of holding your breadth. Try to hold for as long as you can, because you are underwater.

The challenge now is that the economy is doing well, so rate cuts might not happen sooner. Banks were very poor at strategic decision-making when they thought that the low-rate environment would persist “forever”. You heard some of them saying rates will never go up again. It is a classic textbook case of ALCO Committees failing to manage DURATION very well. The same mistake of overlooking seemingly improbable but possible scenarios can happen again. What if rates do not go down again for a very extended period? It's not an impossibility. The US economy has proven to be very resilient. What if the rate of the 10-year can not go below 3% ever again? Surely the Natural rate of Interest (Econ 101) has to be above 2.5%. So why do banks bank on rates staying below this as the normal scenario?

Higher for longer is the risk factor. Higher Forever is not improbable. Higher Forever should be the normal, for the fact that the definition of high is the current environment, which is a low environment in the multi-decade scheme of things.

Real estate loans and Treasury securities have always been safe bets for small banks, but not this time around. The problem is the weight these two have in the asset mix of smaller banks. The same is not problematic for big banks. These asset mix concentration problems are not the only problems faced by small banks.

Deposit Pricing, Mutual Funds, and Private Credit

How much to offer to depositors in terms of interest? This is a problem eating right into the core of the small bank business model. They traditionally raise cheap deposits from their respective catchment areas (regions, communities).

When interest rates are low, deposit pricing is a non-issue. Now that interest rates are up, deposit pricing returns to be a bone of contention on the competitive landscape. It's turning out that small banks are not competitive enough. They used to be, but technological changes over the past decade have improved access. Their client base now has easy access to big banks and most importantly mutual funds.

Thus, mutual funds are turning out to be the real competitor. Not-so-competitive pricing leads to funds leaving a.k.a Deposit Flight.

That's on the deposit mobilization side. On the asset side, once again, there is the Non-Bank Lending issue. Private Credit is booming. It eats into the traditional turf of banks (big or small). It's a general long-term trend where financial intermediation is moving into private markets. Private Credit is the twin to Private Equity.

Guess who it affects the most? Small banks. Large banks can raise funds in the wholesale markets at low prices and can afford to lend some to large Private Credit players who then go wilding in the true private credit markets. So large banks get to participate in the party indirectly. Small banks don’t. They are uninvited.

The death that comes to small banks is slow. There are no bank runs in this. You just get squeezed and squeezed until you can’t breathe.

Related to this and the CRE train is the issue of Credit Quality. Deposit Flight is concentrated on quality clients, who at times also happen to be quality borrowers. When they take their business to competitive big banks, they leave your pool of clients dominated by poor quality clients, which over time increases your credit losses. Your NPLs spike up and become fundamentally different from the NPLs of big banks. In other words, it's the separation. Henceforth, Big Banks shall have low NPLs and small banks shall have high NPLs.

A stellar example of high-quality Deposit Flight is the continued actions of Corporate Treasurers and Small Business Owners. After going through the SVB scare in 2023, they are prioritizing safety over everything. They were traumatized and just the thought of going through the same stress again is enough for them to stay away from smaller banks.

There are other smaller issues too.

Cybersecurity Storm Coming

There is a storm brewing regarding cybersecurity. Cybercriminals have been primarily targeting big banks. This is the reason why JP Morgan says they employ more technologists than FANG companies, most of them are working on cybersecurity.

The faster code development cycles brought around by AI are epicenters, the enablers of problems. System breach events are already going up. Big banks have the resources to weather the storm. Community banks and credit unions don't have these resources. Cybercriminals might decide to target the low-harvest low-hanging fruits. A barrage of successful attacks can trigger an increased exodus of banking business from small banks to “safer” large banks.

Talent Drought and Inability to Leverage AI

When advanced AI gets deployed into banking, it is highly likely to be an advantage for big banks for a longer period before small banks eventually catch on. Well, small banks might not survive long enough to eventually catch on. They don't have access to the talent needed to drive this. It's a talent drought out there for smaller banks.

Small banks don't have the right scale in terms of datasets to train better models and harness efficiencies. Should they decide to purchase GPUs, they will be at the back of the queue, based on NVIDIA’s criticality criterion for deciding who gets these first. This AI is a technology that favors the already large incumbents when it comes to deployment.

Compliance Burden — Basel Endgame 3 for the Bigger Regional Banks

The cumbersome legislation, if approved, will apply to banks with more than $100 bn in assets. This will be a big bank problem. However, there are a handful of regional banks that are above the threshold and have to comply.

Previously, these Basel regulations applied to banks with above $750 bn in assets. So now this will apply to more banks. The regulations will be disproportionately heavier for banks in the $100 bn to $750 bn versus banks above the $750 bn mark.

Big Picture — It’s a Business Model Problem

The regional banking model, the community banking model, and the credit union models are out of sync with modern risk management practices. They are too concentrated on both the asset side and the liability side.

You raise deposits from your community or region and lend to your community or region, which exposes you to idiosyncratic risks peculiar to that catchment area. You are over-exposed to the dominant economic activity in that community/region etc. No single community/region, no matter how self-sustaining it can appear to be, can be regarded as having all the necessary exposures required for a balanced portfolio.

The business model was great for so long. It's no longer the case. Now sound bank balance sheet management requires diversification. There is no premium harvested for concentration, you only get punished. Diversification can only be obtained through scale. You need scale. The importance of scale can never be emphasized enough.

Will Consolidation Solve These Problems?

Yes. The answer is yes, for most of the problems. The problems are primarily due to the absence of scale. Consolidation allows for some scale.

If a regional bank with a $100 bn asset size and 27% exposure to CRE merges with another regional bank of the same size but with only a 6% exposure to CRE, the resulting bank will have a $200 bn asset size with a 15% exposure to CRE. Both banks benefit from this transaction. One gets lower exposure to CRE and the other gets higher exposure to CRE but obtains scale, a necessary precondition for survival. The one with lower CRE exposure can choose not to merge. They can watch and wait for the high-exposure bank to fail. When this happens, the banking business does not flow to the low-exposure bank, no, it flows to the big banks. JP Morgan Chase grabs the share left, further bulking up into a size that dwarfs the small low CRE exposure bank.

Consolidation does not guarantee survival, even though it helps a lot. As of December 2023, the top bank, JPMorgan Chase had an asset size of $3.3 trillion, that's some serious scale. If you want to compete effectively you have to get that level of scale.

JPMorgan Chase $3.3 trillion in assets; Source:

If we are to create buckets of $3 trillion-sized banks out of the Fed data set with 2129 institutions, we will have to combine the bottom 2029 banks for them to create one giant.

To get to at least $3 trillion in asset size, 75 banks ranked from number 26 rank onwards have to merge into one institution. That generates the scale necessary to compete with JPMorgan Chase.

Bank Buckets by Asset Size; Source Data from Federal Reserve

The point here is that no amount of reasonable consolidation can guarantee scale and survival. The top 4 big banks have the scale advantage, good luck to the rest in trying to compete.

By the way, the buckets picture is the way banking is headed. That’s the end goal. It has already happened in other sectors. At least, these buckets create a Big 7, not a Big 4 or Big 3. The Big 7 only happens if the small banks are allowed to consolidate, otherwise they just gradually drop out of the equation, one failure at a time, until we are left with the Big 4.

Scale is the keyword. Always remember that.

It is easier for JP Morgan to grow the asset size from $3.3 trillion to $4 trillion than it is for the aggregate asset size of Banks 101 to Bank 2129 to grow by the same magnitude.

That brings us to the opportunity in front of the big banks.

Opportunity for the Big Banks

Failed consolidation of regional banks = market-grabbing opportunity for the big banks. If the FTC and Competition Commission prevent the small banks from consolidating, they effectively give them a death certificate. When the small banks exit, the big banks step in to grab the business left behind.

If small bank failures are managed in a manner where the dying ones are auctioned off, it’s the big banks that stand to benefit as well. They buy up these small banks pennies on the dollar. When they appear as white knights, it is hard for the regulators to stick to the anti-trust gospel. JP Morgan can emerge with a trillion-dollar valuation after all is said and done if it grabs a couple of regional banks in the process. Remember in 2008 JP Morgan was the healthiest of them all, it swallowed a few weak ones and became a mega bank thereafter.

“Jamie Dimon” waiting for the CRE train to wreck small banks

The anti-trust fellas are given a conundrum. If they allow small banks to consolidate, small banks will consolidate into fewer bigger banks. If they stop small banks from consolidating, the banks fail outright or struggle to exist as a shadow of their former selves. The market share ends up going to big banks. Consolidation will happen either way. Banks shall consolidate. It’s a path ordained by the economy.


The best foot forward is for larger regional banks to go around acquiring community banks. That will diversify the asset mix, get a wider deposit base, and deconcentrate risks. J-Powell, at the Federal Reserve, is in support of consolidations. The anti-trust fellas and Biden’s administration will have to give in, given the do-or-die scenario facing small banks vis-a-vis big banks. Consolidations don't guarantee future success but they give small banks a shot.