Trump Bank Run?

Will Deregulation Blow Up The Banking System?

In the last week, a wave of stories have discussed Trumpʻs plans to cut bank regulations, possibly going as far as abolishing the FDIC, one of the banking industryʻs main regulators.

The Trump camp has many gripes with the industry, from over-regulation, to de-banking of politically disfavored persons (Marc Andreessen recently revealed that members of Trump’s family were booted from the banking system) to discrimination against entire industries in the Chokepoint 2.0 program.

The response online has ranged from disbelief to anger, with some warning that the changes could trigger a new wave of banking crises. But how severe is this risk really?

Polymarket has an active market forecasting US bank failures. The market will resolve to “yes” if any bank is added to the FDIC’s failed bank list by the start of Q1, 2025. As of today, that risk sits at 30%, just under 1-in-3. But what’s driving this? And how big of a risk does it pose to the financial system?

Boom and Bust

The FDIC’s failed bank list begins in the year 2000 and includes 570 banks. To get a sense of whether the 30% number on Polymarket represents an elevated level of bank risk you can calculate average bank failures per year (570 bank failures / 24 years = 23.75 bank failures per year) — almost two per month. From this, it would seem that traders on Polymarket are drastically under-estimating the risks of a bank failure.

But if you look at a histogram, it becomes clear that there are big outlier years around the time of the financial crisis, which took several years to normalize. So it makes more sense to separate bank failures into normal years with 3-4 failures and crisis years where you would expect many multiples of this.

In today’s macro climate, analysts have focused on three main risks to the banking system: exposure to commercial real estate (CRE), liquidity issues, and regulatory uncertainty stemming from Trump’s re-election. Let’s examine each one.

Commercial Real Estate Vacancies Remain High

Source: Statista

Office buildings across the United States are still reeling from the shift to remote work. Vacancy rates remain high, leading to rental income declines and plummeting property values in office real estate.

For smaller and mid-sized banks, the exposure to CRE is significant - averaging around 29% of their portfolios. In comparison, large, diversified banks only hold around 7% in CRE loans. Small and midcap banks (e.g., East West Bancorp, M&T Bank, SouthState Corporation) hold around ~39% of their total loans in CRE while large cap banks (e.g., Bank of America, Morgan Stanley, & Citigroup) hold ~8% or less of their total loans in CRE.

The problem is compounded by a looming refinancing cliff. According to Commercial Real Estate Daily, 15% of maturing CRE loans in 2024 are considered “too hard to refinance”due to elevated interest rates, tighter lending standards, and declining valuations. With over $500 billion in CRE loans maturing this year, defaults could surge. For banks heavily exposed to CRE, these defaults could force write-downs, eroding capital reserves and pushing some institutions toward insolvency.

Liquidity Pressure

Liquidity issues remain a lurking threat, even after the closures of Silicon Valley Bank and Signature Bank in 2023. Many regional and mid-sized banks are still experiencing deposit flight as customers seek higher yields in money market funds and treasuries.

While the Federal Reserve's emergency lending facilities have provided temporary relief, persistent high interest rates continue to strain bank balance sheets. In the 2023 mini-banking crisis, we saw deposit flight from small- and midsize-banks to the “too-big-to fail” banks that carry an implicit government guarantee. The FDIC’s actions to make depositors whole above the statutory $250,000 threshold eased, but did not eliminate this dynamic.

If a wave of CRE defaults or deposit withdrawals occurs, even a minor liquidity shock could destabilize a fragile bank and cause a repeat of capital flight from smaller banks.

Regulation: Cut or Streamline?

Adding to these macro issues is the current climate of regulatory uncertainty as the Trump administration, with Elon Musk and the Department of Government Efficiency (DOGE), seem to be preparing for a massive shake up of the federal bureaucracy.

Trump’s re-election and the appointment of Paul Atkins as the new SEC Chairman may signal a shift in focus away from traditional banking oversight. Atkins has been openly critical of bank regulations such as Dodd-Frank for giving regulators too much authority, indicating that the law allows “government, and not the markets, to choose winners and losers.”

At the heart of a recent controversy was the Wall Street Journal article headlined “Trump Advisers Seek to Shrink or Eliminate Bank Regulators.” The article mentions that potential Trump banking regulators have been asked whether it is possible for the FDIC to be eliminated.

Critics have responded with comparisons to the bank run depicted in It’s a Wonderful Life, cautioning of a world where Federal bank deposit insurance is a thing of the past.

But the WSJ article makes clear that the Trump administration is not contemplating eliminating deposit insurance altogether. Rather, it is considering moving this function to a separate agency to streamline government.

The article also mentions that eliminating a federal agency would require an act of Congress and be unprecedented in American history. While Polymarket does not have an active prediction market on FDIC shutdown, there is a market on whether the Department of Education will be cut – another Trump campaign pledge. This market is currently pricing a 14% chance that the department is eliminated by the end of April.

Elevated Risk?

But even if cutting the FDIC is a longshot, is it possible that Trump’s deregulatory agenda, embrace of crypto, or the other macro risks above could trigger bank failures?

Let’s go back to our baseline non-crisis rate of 3.4 bank failures per year. This implies a ~25% chance of a bank failure in any given month. Yet the Polymarket odds of 30% for a bank failure by April, imply just 11.4% risk of bank failure per month.

Combine this with the rally in bank stocks since November 5 and the market seems to be pricing in a better climate for banking, rather than a period of elevated risk.

Still, the office real estate overhang, and liquidity mismatch between large and small banks remain real risks to the system that will face the incoming administration.

And with Powell’s hawkish comments at yesterday’s FOMC indicating a reluctance to cut rates further (🔮90% odds for no rate cut in January) it seems likely that pressures on underwater office mortgages will persist.

Today, the 30% odds for a bank failure in Q1 of 2025 represent a market forecast of reduced banking risk compared to the historical baseline. But if liquidity tightens, CRE defaults spike, macroeconomic conditions change, or regulatory shifts do indeed cause a crisis of confidence in the banking system, Polymarket’s bank failure market could give an early warning.

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Disclaimer

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