As we approach the anniversary of the collapses of Silicon Valley Bank and Signature Bank, Monitor explores how the resulting turmoil in the banking industry has impacted equipment finance. Will banks continue to dominate this industry or are their days numbered?
Banks have been steadily increasing their presence in equipment finance over the years via mergers and acquisitions and by hiring experienced leadership teams. When the Monitor 100 launched in 1992, U.S. bank affiliates contributed 17% of the ranking’s net assets. Today, the share of banks is 52.9%, but will banks continue to dominate the industry?
Skyrocketing Interest Rates
The regional banking industry faced myriad challenges in 2023. Many agree that the Federal Reserve’s decision to raise interest rates 11 times between March 2022 and July 2023 set the stage for turmoil.
“The interest rate environment has had a disproportionate impact on banks depending on balance sheet positioning and business model,” Dave Drury, senior vice president and group head, Equipment Finance at Fifth Third, says. “In general, higher rates have tightened liquidity broadly and increased the cost of borrowings. This has placed greater emphasis on ensuring strong returns on capital, which, combined with tighter liquidity conditions, has impacted lending.”
When interest rates increase, Monitor Editorial Board member Vince Belcastro notes that the “weakest of borrowers” are often hit the hardest, which impacts their financials and can lead to defaults or covenant violations designed to restrict the amount of debt the borrower can carry or how much interest can cover. The higher interest rates go, the more struggling borrowers become exposed, forcing banks to reevaluate and re-grade their credit portfolios, which, in turn, affects bank credit quality ratings and reserve requirements.
In 2023, S&P Global lowered the ratings of nine banks, revised the outlooks of five banks to negative and revised outlooks to stable for four banks which were previously rated positive.
Deposit Dilemma
When the credit quality and rating of a bank’s portfolio drops, its capital requirements increase. Belcastro says banks in this situation face a trifecta of hurdles, including increasing reserve dollars, improving their overall credit ratings and facing the increasing cost of capital.
From Q4/22 to Q1/23, deposits decreased by $472.1 billion at U.S. banks, marking the largest decline reported by the FDIC in the history of its data collection. As economist Dr. Elliot Eisenberg mentioned in a recent livestream event, the excess pandemic cash that consumers and businesses had been saving for a rainy day was quickly consumed due to rising inflation.
“Deposits are critical to a healthy banking franchise, and a strong stable deposit base can ensure consistent lending in all business environments,” Drury says. “Banks with well diversified, stable deposit bases tend to be more resilient and consistent in various business cycles and under stress.”
Meanwhile, according to the FDIC, the cost of deposits has continued to increase faster than loan yields, despite steadily increasing net interest margins since 2022.
“To be sure, across the banking sector, the rate environment has led to a greater focus on building or retaining deposits; there has also been significant pressure on net interest margin, and we’ve seen the reports where some companies are reevaluating portions of their bond portfolios that were underwater,” Will Perry, executive vice president and group head, Regions Equipment Finance, says. “All that said, as we look back on 2023, with only the very few exceptions we saw back in the spring, the nation’s banks have proven themselves to be resilient and well capitalized.”
“When regulators come in, they look at loan-to-deposit ratios,” Belcastro says. “Yes, their loan-to-deposit ratios have gone down, but deposits as a whole are still stronger than pre-pandemic. Despite the fact that deposits are still higher than pre-pandemic levels, they’re definitely lower than they were six months ago.” Belcasto notes that this trend, coupled with potentially increased lending and investing activity can cause lowered loan-to-deposit rations, which, in turn, can constrict lending activity.
S&P Global Ratings predicts that deposits will continue their descent until the Fed reaches the end of its quantitative tightening, meaning depositors will require higher yields to avoid making further withdrawals.
Reserve Requirements
Designed to preserve liquidity, reserve requirements were officially mandated in the U.S. when the National Bank Act passed in 1863. Today, the Fed uses these requirements as a component of monetary policy.
“Banks must maintain a buffer of liquid assets to offset potential outflows under times of stress,” Drury says. “The amount of this buffer is quantified by banks’ internal stress testing process, which is subject to regulatory review under Regulation YY. Since the bank failures in March [2023] and given tighter liquidity conditions, banks are carrying larger liquidity buffers out of caution. This demand to hold more capital and liquidity in this environment does impact a bank’s ability/willingness to lend.”
Effective March 26, 2020, in response to the COVID-19 pandemic, the Fed reduced reserve requirements to 0% to provide banks with more liquidity to lend. As deposits rolled in, increasing by 21.7% in 2020 — the largest jump in nearly 80 years — banks were flush with cash. While many initially pulled back investment in 2020, as evidenced by a 13.9% year-over-year drop in originations in 2020 by Monitor’s Bank 50 ranking, the group quickly got back in the lending game and increased equipment lease and loan volume by 6% in 2021.
“Without question, I expect [reserve requirements] to be a source of continued discussion and debate in the industry moving into 2024 and beyond,” Perry says. “And I believe across the financial sector, you’re seeing companies becoming more selective about where they are deploying capital for a variety of reasons.”
Banking Breakdowns
When it came to deploying capital during the deposit boom of the pandemic, some, such as Silicon Valley Bank, chose to invest overflowing deposit coffers in treasury bonds, traditionally viewed as low-risk investments with lower yields. As interest rates rose, SVB’s treasury bonds became less attractive to investors, which caused them to drop in value. Meanwhile, as inflation hit record highs, the bank’s technology startup clients began tapping into their deposits. To meet its capital needs, SVB began selling investments, resulting in a $1.8 billion loss for the bank that caused its stock prices to plummet.
We all know what happened next. Five U.S. banks — including equipment finance player, Signature Bank — failed in 2023, sending shockwaves around the globe and causing banks to reevaluate their investments.
Some, like Belcastro, argue that heavy reliance on cryptocurrency deposits at Signature Bank and SVB led to challenges; regulators disapproved of crypto deposits, which led to an imbalance in loan-to-deposit ratios and insolvency issues.
Regardless of their root, Paul Vecker, chief revenue officer at Eastern Funding, says the bank failures sparked panic in many depositors, leading them to withdraw funds, which impacted the ability of smaller banks to lend.
“You started seeing a lot of lenders pull back on their ability to lend because their capital base has been depleted by the depositors leaving,” Vecker says. “And that hasn’t changed. And quite frankly, I don’t know what these small to mid-sized banks are going to do to try and bring depositors back in.”
Despite the ongoing press about the situation, Perry does not believe that the recent bank failures directly affected the equipment finance sector. “Remember, the banks that failed had very different business models than most other banks,” Perry says. “Most banks are built around a diversified business model that reaches a large range of clients, whereas the banks that failed focused largely on just a few core types of clients. In my experience, clients looking for equipment financing have turned to banks with diverse business models. And those banks are still operating from a position of strength today.”
Impact on Customers
Ultimately, banking turmoil has affected many customers over the last year. Vecker believes the series of interest rate hikes led to a “paradigm shift” in the market.
“We, as the equipment finance company, are no longer able to say to our customers, ‘This is what your interest rate is going to be regardless of when your deal closes,’” Vecker says. “Because in an environment where an aggressive Federal Reserve is taking unprecedented action to quash inflation, you have too much volatility to try and hold rates beyond a day or two. If you did, you are taking on a lot of rate risk, which could destroy any margin you have in the deal.”
To further complicate matters, Vecker says -certain markets continue to deal with ongoing supply chain challenges, which complicate equipment orders, leading to uncertain delivery times and oftentimes preventing manufacturers from providing final sale prices. This creates the dual challenge of both equipment price uncertainty and rate uncertainty occurring at the same time.
To address this uncertainty, Vecker’s company began to offer insurance designed to lock in interest rates and eliminate at least one of the two new risks in the market. But insurance is merely a band aid on greater issues at hand.
Economic Headwinds
Although the U.S. economy remained resilient in 2023, S&P Global predicts its strength will be tested this year as the actions of the Fed continue their ongoing ripple effect. Economists continue to speculate about when the Fed will begin to lower rates. S&P suggests two possibilities: 1) when disinflation moves closer to the Fed’s goal of 2% and 2) when unemployment numbers begin to rise.
At its January 2024 meeting, the Federal Open Market Committee decided to hold steady on rates, and with the consumer price index landing higher than expected in January, a decision to lower rates at the next FOMC meeting in March seems uncertain.
“We’re starting to see the impact of hyper-inflation and 18 months of interest rate increases on the economy,” Vecker says. “And so, credit departments at banks are starting to be significantly more cautious about the type of lending they do. You can’t ignore the environment.”
If this weren’t enough, The Alta Group notes that the resulting geopolitical tension of two ongoing wars is contributing to the uncertainty of many equipment finance leaders. Additionally, indicators of potential economic slowdown and concerns about a recession have led to the tightening of lending standards.
S&P forecasts that delinquencies and charge-offs will continue their upward trajectory, heading close to historical averages in a slow growth environment of limited economic growth, with continued decreases in deposits, coupled with pandemic-induced stress in commercial real estate.
Commercial Real Estate Exposure
Many companies have struggled to get employees back in the office after the COVID-19 pandemic, and the repercussions have hit the commercial real estate industry hard. As of November 2023, U.S. banks held approximately $3 trillion in CRE debt.
Sparked by rising concentrations of CRE loans in the early 2000s and lessons learned from bank failures in the 1980s and 1990s, the FDIC, Federal Reserve Board of Governors and Office of the Comptroller of the Currency published guidance on the concentration of CRE loans. Banks with 1) “construction loans surpassing 100% of risk-based capital,” 2) total “CRE loans above 300% of risk-based capital” and 3) “50% growth in CRE over the last 36 months” were all considered risky. In June 2023, 483 banks exceeded guidelines in category one and 1,020 surpassed guidelines in categories two and three.
Traditionally, owner-occupied CRE loans have performed slightly worse than non-owner occupied CREs, but in 2020, that trend reversed and delinquency rates for non-owner occupied CREs have continued to rise ever since. The portfolios of many well-known banks active in the equipment finance sector, including Western Alliance, Wells Fargo, CIBC, BankUnited and Citizens Financial, made the list of the top 25 U.S. banks by highest non-owner-occupied CRE concentration in Q3/23, according to S&P Global.
Fitch Ratings expects the quality of CRE loans to continue deteriorating into 2025, with office properties leading the downward charge. Fitch estimates that loan delinquencies for U.S. commercial mortgage-backed securities will double in 2024 and reach almost 4.9% by 2025.
In the aftermath of last year’s banking collapses the Wall Street Journal reported that the SEC is doubling down on some community and regional banks regarding their CRE exposure and watching intently to ensure that these losses do not create a repeat of the Great Recession.
As commercial real estate and commercial equipment finance are often linked in the organizational structure of some banks, how will this impact the industry?
Long-Term Outlook
The whirlwind of post-COVID financial industry trends has already created repercussions for banks in equipment finance. Belcastro notes that banks are likely to continue to adopt a more conservative approach to capital management, potentially reducing their involvement in equipment finance and commercial lending in general.
Some U.S. Bank Affiliates with significant equipment finance portfolios, like Key Equipment Finance, have already scaled back operations. Over the next few years, Belcastro says banks may decrease their lending and leasing activities, impacting their share in the equipment finance industry.
Vecker points out that one of the challenges that equipment finance subsidiaries of banks have is that often, a fair amount of their business is done with customers that have no other relationship with their parent bank: “Often our only relationship with the customer is through an equipment finance transaction. We don’t generate fee income on ancillary products or bring deposits in. So as a consumer of the bank’s precious capital, we better be able to return that capital at a higher rate than other lending products where the bank can enjoy a broader relationship with that customer. As a highly specialized lending product, we have been able to provide that superior return to the bank and expect to continue to be able to do that in the future.”
Drury does not expect banks to pull back from equipment finance: “There may be some individual circumstances as we’ve already seen; but, broadly, I don’t see banks pulling back from what I like to call the ‘core’ equipment finance market, which is doing traditional lease and loan products as generalists, with select asset and/or industry specialization and a focus on its clients and prospects in the markets it serves.
“My personal view is that, with the industry being a $1 trillion sector, banks that choose to compete in the space must have a viable equipment business in order to compete effectively. As someone who has helped build a de novo equipment finance business for a bank, I also think there will continue to be opportunities for banks to continue to build domain expertise in this space leveraging talent that may become available from elsewhere.”
Perry believes fewer banks will be entering equipment finance: “I see the trend slowing considerably within the banking sector in 2024. The reason for this, in my view, is a combination of the current economic climate and the work the acquiring banks are doing to organically build on the growth they’ve experienced since enhancing their equipment finance capabilities in recent years. I believe 2024 and likely a good part of 2025 will be exciting times that will present a great deal of strategic opportunity.”
And for banks already in equipment finance, Perry believes balance sheet strength will determine a bank’s staying power: “There will be, and already have been, institutions that have scaled back, which will position others for greater opportunity. Our customer-centric approach at Regions Equipment Finance has been in place for decades and has allowed us to serve our bank partners and existing clients with specialized guidance and industry expertise.”
As many banks have reduced their equipment finance offering to a mere product offering, The Alta Group has identified the opportunity present for independents and captives in the industry to capture market share.
Impact on Syndications
Banking turmoil also made a material impact on syndication, as an exit of players coupled with increased pricing and credit approval is putting a damper on a once-thriving market.
“Syndication has absolutely been impacted,” Drury says. “As banks deem their capital to be more precious, each has had to make decisions on how to best allocate that capital. Some banks have pulled back or exited their buy desks entirely, which has an obvious impact on the syndication marketplace, changing the dynamic in the investor pool many syndication desks have traditionally relied upon. That said, our industry has demonstrated over time to be exceptionally resilient, and I expect others will step in to fill any void created by some banks’ decisions in this area.”
Belcastro predicts that private credit funds may fill this gap, playing a more significant role in syndications, which could potentially lead to higher borrowing costs for equipment finance clients.
“If disciplined and used correctly, there’s great utility for equipment syndication, especially during times of turmoil and change,” Perry says. “This agility enables banks to strategically divest of or acquire assets in large quantities, generating income, manage industry and sector collateral while prudently managing credit risk. Interest rates influence banks’ desire to sell assets out of their portfolios. Depending on the interest rate, divestitures may result in losses.”
Predictions
Assembled from the wisdom of the industry experts interviewed and publications researched for this article (with perhaps a bit of crystal ball scrying thrown in for good measure), Monitor has assembled a non-comprehensive list of predictions for equipment finance in the year ahead:
No matter what the future brings, one thing is certain: equipment finance is here to stay.
“In my experience, leadership that takes a calculated, strategic and disciplined approach will be rewarded in normal markets and even more so during times of uncertainty and change like today,” Perry says. “We continue to stay focused on serving our clients, welcoming new clients who align with our risk appetite, and investing in our associates. Most recently, economic observers have added to the hopes that many have of a ‘soft landing’ in the economy. We’d love to see that, too. But we’re prepared for whatever comes.”
One Reply to “What Does the Future Hold for Banks in Equipment Finance?”
Great article…