Shares of smaller lenders sink once again, reviving fears about the banking sector

Hours after JPMorgan Chase took over First Republic Bank, Jamie Dimon, the CEO of the largest lender in the U.S., called an end to the bank turmoil that had enveloped the country's smaller lenders since March.

"This part of the crisis is over," he told Wall Street analysts.

Days later, there are signs that, instead of it being over, the turmoil in the banking sector may be entering a new phase.

The sale of First Republic after a brief government takeover early on Monday had marked the third bank failure in two months, after Silicon Valley Bank and Signature Bank.

Markets initially breathed a sigh of relief on Monday. But the relief did not last long.

Shares of a slew of regional banks, including most prominently PacWest Bancorp and Western Alliance Bancorp, have fallen sharply in recent days, as Wall Street worries other lenders could be vulnerable to bank runs.

On Thursday alone, PacWest slumped just over 50% while Western Alliance lost 38%.

The sell-offs come even though there are no signs of widespread problems in the small banking sector, and despite repeated reassurances by top regulators, including the Federal Reserve and the lenders themselves.

Here is what's happening with small banks.

Why are other smaller lenders under pressure?

Just like the three failed banks, many of the smaller and regional banks being targeted have a lot of deposits that are too large to be insured by the Federal Deposit Insurance Corporation (FDIC).

Investors also worry about unrealized losses in lenders' portfolios, including government bonds that have lost value since the Fed started raising interest rates aggressively last year.

They are also concerned about banks' exposure to commercial mortgages that are vulnerable as offices across the country remain vacant.

Wall Street fears these banks wouldn't be able to withstand a big outflow of deposits if customers left for the perceived safety of bigger banks.

A lot of the investors betting against these smaller lenders are short sellers, that is, those who are literally betting regional bank shares are going to go lower.

The banks have responded by trying to convey to their customers — and investors — that they are well capitalized.

In a statement, PacWest, which has 70 branches mainly in California, said that it had actually seen an increase in core deposits while saying its cash holdings and available financing exceeded the amount of its uninsured deposits.

Meanwhile, Phoenix-based Western Alliance said 74% of its deposits were insured — meaning they were $250,000 or less. It added that among its 20 largest depositors, almost 90% of their deposits are insured.

Other lenders have also taken steps to reassure investors, while Fed Chair Jerome Powell on Wednesday said that "the U.S. banking system is sound and resilient."

So why are these reassurances not calming nerves?

In a word: fear.

At a time when the overall economy is fragile, there continues to be a lot of uncertainty about the outlook for markets.

The Fed has embarked on its most aggressive interest rate hiking cycle since the 1980s. And although it signaled on Wednesday it may be done with rate increases for a while, there are growing fears that the higher borrowing costs, combined with the banking turmoil, will throw the economy into a recession.

But there is still a worrisome disconnect between what the financials of the banks being targeted actually show and what Wall Street believes.

"Stock volatility is not indicative of deposit instability," wrote Jefferies bank analyst Casey Haire in a note to clients about Western Alliance.

What else are banks doing?

Some of the targeted banks are urgently looking to shore up financing by, for example, looking for additional investments.

In a statement, PacWest said it is in talks with "several potential partners and investors" while also looking to sell some of its assets.

Meanwhile, Western Alliance strongly denied a media report it was contemplating a sale. It said it is "a financially sound and profitable bank."

So how could all of this end?

It's very hard to say.

A continued fall in shares could endanger these smaller banks, motivating customers to withdraw their money and sparking the kind of bank run short sellers are betting on.

That would put additional pressure on the government to step in yet again.

Regulators took the unprecedented steps of insuring all deposits at Silicon Valley Bank and Signature Bank, including those above $250,000, by arguing the failures of the lenders posed a risk to the broader financial system.

But in the case of First Republic, the government was keen to find a private sector solution. It conducted an urgent sale process that JPMorgan Chase won.

Any additional government interventions would be controversial given that it could lead to even more expectations of a regulatory rescue.

It could also be costly.

Insuring all deposits at Silicon Valley Bank and Signature Bank cost the Federal Deposit Insurance Corp over $22 billion. The regulator plans to make up the shortfall with a special fee on lenders though it has not decided which ones need to pay.

Meanwhile, the FDIC estimates the failure of First Republic will cost the FDIC $13 billion.