Margin Call is a 2011 financial drama starring Kevin Spacey and Jeremy Irons. The story takes place over a 24-hour period at a large Wall Street investment bank during the initial stages of the 2007 – 2008 financial crisis. In focus are the actions taken by a group of risk managers to help the firm narrowly avoid bankruptcy over toxic assets. Flash forward to the regional bank deposit-crises of 2023, which similar to the Great Recession of 2008, might be a catalyst to shift risk to smaller non-banks. Simply stated,  new regional bank regulation might the be the spark to create a boon for non-bank lenders focused on the lower end of the market. Ironically, it might be the other “R” word, Regulation, rather than recession that drives business to non-banks that have competed aggressively and lost against regional and community banks. There is past precedent as the rise of large, multi-billion-dollar direct lending funds can be traced back to the events and subsequent regulatory actions from the Great Recession in 2008.

2008 was an epic global banking crisis, centered mostly around the nation’s largest banks, that caused fears from both Wall Street and Main Street of existential systemic risk. With existential risk comes government shaming, scapegoating and of course regulation. The events of 2008 led to significant big bank regulations that have so far been effective. This led to the proliferation of BDCs and a shift to large non-bank direct lending which can be at partially tied to the new regulations that came from 2008. According to reports, BDCs have tripled assets outstanding since 2008. What 2008 didn’t do was to over-regulate smaller banks that did not pose a systemic risk or really engage in risky trading behavior. The question to ask is whether new regulation will cause a dramatic shift to non-bank lenders in the lower middle-market similar to how large funds benefited from 2008 big-bank regulation.

Regulators spent the past decade focused on regulating systemic risk concentrated within a few trillion-dollar banks and were less worried about a handful of $50-plus billion banks. Similar to 2008, it was unfathomable, from a regulator’s perspective, that we could actually face a run on smaller stable banks, but not large systemic ones. The failure of Silicon Valley Bank (SVB) and subsequent panic are only ironic in the sense that typically credit losses cause capital losses and a proverbial run on the bank. Regional banks have by and large been unscathed by regulatory efforts as while critical, they have not been deemed existential or largely engaged in the toxic behavior that incited the 2008 financial crises. New regulation will for sure cause regional banks to tighten lending standards.

Ten years ago, the world was focused on the heart of U.S. financial system and less so on the arteries (regional banks) that do the day-to-day banking work of the U.S. economy. Many of these regional banks went on an acquisition spree that created many super regional banks that were hard hit the past few weeks. This means that many of these banks had more lending flexibility and less supervision than the nation’s biggest banks. Let the author avoid doubt, this does not mean that any banks were reckless or even had subpar risk management, but it does mean that they had less capital, more flexibility and more discretion.  

Today the nation’s biggest banks are, from a regulatory standpoint, quite safe with strong capital bases and geographically diverse retail deposit bases. When the majority of their customers are spread-out across the country and hold less than the FDIC insured amount, there is no need for a run-on-the-bank. Contrast that with the regional banks whose depositors are geographically concentrated. These banks pose minimal systemic risk, but do now pose community risk to smaller and mid-sized businesses. From a wealthy depositor’s perspective, is the reward of 1 percent higher on deposits worth the binary risk of no FDIC insurance? The answer is no. This means that all wealthy depositors now realize they are effectively unsecured creditors of many banks that don’t face existential threats. While it’s unlikely and would be a policy error to let a regional bank of any size not honor its deposits, it’s not impossible. If there is a 1 percent chance something might happen, then it probably will to someone. Wealthy folks are typically savvy enough to not be that someone.

In most classic cases of bank failures, credit issues lead to capital issues, which typically lead to bank shareholder dilution at best and FDIC take-over at worst. What’s so unique about SVB and many regional banks is that capital issues may drive credit issues, perceived or real, that may in-turn cause capital issues. Regional banks, by and large, have been left unscathed by focused regulatory scrutiny as compared to the nation’s biggest banks. Why focus on a $30 billion bank with $2 billion market cap when you have 10 or so banks that collectively have trillions of dollars. The systematic risk is not the same nor are the businesses. So here we find ourselves in a black-swan situation where capital issues in form of smaller deposits might expose credit issues that will for sure in turn drive capital issues. Regional and larger banks were aggressive with new business and light on costs for special assets and other areas as the need has not been evident. In addition, deposits have been overwhelmingly strong, so the capital base could afford to be very, very patient.

Via government intervention, confidence has at least been temporarily restored to the regional banking system, but regulators are now turning their attention to regional banks. A few things are clear, firstly, not every regional bank is created equal in terms of business focus (i.e., C&I versus Real Estate versus other assets and depositor base).  Secondly, while regional banks have faced regulatory scrutiny, they have not had the spotlight focused on them. Many of these banks were the take-out options from the big banks and now will look for an outlet to take a risk-off approach. This would be a prudent thing to do irrespective of regulations in order to free up capital but should be a priority in light of the regulatory and potential transitory nature of all depositors right now.

The end of the movie went as expected. The Wall Street bank that first realized its toxic assets were worthless held a fire sale and survived. As trading progresses, the firm elicits suspicion and eventually anger from their counterparties and incurs heavy losses, but they are able to sell off most of the bad assets. The non-bank world is standing by to be a partner to the banks who by and large have strong loan books but need a partner to risk-off. The banks need not worry as most folks in commercial finance don’t use Twitter!