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As community banks face a challenging operating environment due to higher-for-longer interest rates and heightened regulatory scrutiny, Tony Scavuzzo, managing principal at Castle Creek Capital, expects private equity investing in the sector to increase.

The private equity veteran expects new investments to support independent banks facing liquidity pressures as well as institutions looking to play offense and purge underwater bonds or credit risk in their loan portfolios. Scavuzzo also expects private equity firms to help facilitate bank M&A activity.

"The interest rate risk, liquidity risk has become a real problem. And as a result, I think you see a lot of banks that are really struggling with both of those issues," Scavuzzo said in the episode, recorded on Oct. 24. "There's folks that think that there's a credit event coming or a recession of some sort. And if you layer that on top of depleted capital and depleted liquidity, it could really create a problem and create a need for capital in the sector."

Bond portfolios across the banking industry remain underwater due to the sharp increase in interest rates over the last 18 months. While most banks feel the sting of sitting on low-yielding bonds while funding costs continue to rise, only a few institutions have sought to reposition their portfolios due to the punitive capital hit associated with such a transaction. Some banks did sell bonds at a loss in the second quarter, and a few more, including Bank of Hawaii Corp. Cadence Bank, FB Financial Corp., and SmartFinancial Inc., have announced similar pruning during the third-quarter earnings season.

Scavuzzo said if banks are restructuring their bond portfolio and reinvesting proceeds into higher-yielding securities, one could argue that the economics are not changing. But, a bank could be sick of having 10% of its balance sheet creating a capital hole, and restructuring the portfolio and reinvesting in higher-yielding securities allows the institution to put the problem in the rearview mirror.

"I think there are folks that are motivated that way just to clean it up and move on," he said.

Many banks' loan portfolios carry below-market yields as well, but credit quality has held up for the majority of institutions. Scavuzzo said he has not seen much credit stress beyond a few "one-offs" but noted that it is hard to imagine a world where loss content does not rise given the sharp increase in interest rates in just 18 months.

If a bank facing liquidity pressures layers heightened credit losses onto its balance sheet, it could face considerable challenges. Liquidity pressures have already been pronounced enough to smother net interest margins at some banks. In fact, of the 3,880 banks that had filed third-quarter call reports as of Oct. 31, 144 had net interest margins below 2%. That is up from 113 institutions with margins below 2% in the second quarter when examining the same group of banks, and 60 in the year-ago period.

Scavuzzo said banks with margins in the low 2s could struggle to remain profitable without some type of restructuring or cost reduction. He expects that dynamic to create a problem for some bank boards and spur more recapitalizations and M&A activity with the backing of private equity in the sector similar to the structure of the merger between Banc of California Inc. and PacWest Bancorp

"I think it will catalyze folks to become more active or more proactive in trying to fight the best they can against this environment," Scavuzzo said.

Scavuzzo expects activity to increase as banks accept the currently low level of valuations. He said the banking sector is trading at the second lowest valuation since the Great Recession, and boards and management teams do not want to sell at depressed levels. However, he said that sellers that are willing to take stock of the right partner as currency in the deal can eventually ride the wave up after the transaction closes.

"I think the faster folks accept that reality and why they're trading below tangible book value, I think that will start to unlock more deals," Scavuzzo said. "I think if people can really pick the right partner and truly believe that, 'Hey, I may not be selling for a historically large premium, but I'm partnering with the right partner, and I'm going to get their currency at a relatively inexpensive valuation, as well. And we're willing to believe that 1 plus 1 is 3 and partner with them and take their currency.'"

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.}