Recent headlines have been dominated by the stress in the U.S. banking system. Both Silicon Valley Bank (“SVB”) and Signature Bank failed in Q1 and were taken over by the Federal Deposit Insurance Corporation. These failures were followed in Q2 by the fall of First Republic Bank, the second largest bank failure in U.S. history. These headlines have us wondering – what bank is next and when will it end?
As more evidence surfaces regarding the cause of the failures, two key issues have emerged. First, certain banks did not properly hedge interest rate risks on holdings, which hurt their ability to meet withdrawals. Second, social media accelerated the “bank runs” (i.e., customers racing to withdraw money).
When banks take deposits, they can lend the money out, or they can invest in securities like U.S. Treasury Bonds and mortgage-backed securities. The value of these securities changes as interest rates rise and fall, and banks normally hedge this price risk. However, the Wall Street Journal has reported that for the 24 large banks in the KBW Bank Index, the unrealized losses on long-term holdings grew by about $300 billion during 2022. Per the Wall Street Journal chart below, certain banks, like SVB, have large losses relative to their size given a lack of interest-rate hedging.
Looking ahead, one alarming fact is that money continues to leave regional banks. Banks have been paying very little interest, and as the Federal Reserve Bank (the “Fed”) raised the Federal Funds Rate, money began leaving banks for higher paying alternatives such as Money Market accounts and short-term bonds. Bianco Research created a chart that shows weekly deposit flows from U.S. banks, excluding “Jumbo CDs,” and it shows a steady exodus of deposits following the “wake up call” from SVB.
Banks are under considerable strain both from deposit outflows and from a profit margin perspective. The Fed stepped in with a new program, the Bank Term Funding Program (“BTLP”), to reduce panic by providing liquidity. With this program, the Fed is agreeing to provide loans to banks to meet redemptions based on the cost-basis of bank assets (e.g., Treasury bonds and MBS securities) rather than the current value of those assets. The Fed’s report to Congress on the BTLP confirms the cash need as $83 billion in loans were outstanding as of April 30. This is an important tool given the massive unrealized losses that have been incurred by banks.
While the BTLP is a good short-term solution to reduce panic and enable banks to meet withdrawals, it doesn’t address the current structural issue: namely, a flat or inverted yield-curve (a situation where longer-dated treasury bonds have a lower yield than short-term bonds) that challenges the profits of banks as they compete for deposits at high rates but have limited options for earning attractive yields on longer-term assets. More strain is likely to come throughout the year as this economic reality begins to appear in quarterly bank profits. The Fed’s plan to hold the Federal Funds Rate at/near current levels will be challenging to the banking sector. Stock prices confirm the strain as KRE (the regional bank ETF) was down as much as -38% YTD through May 4.
The Fed is driving the ship regarding future bank failures. Keeping the Federal Funds Rate elevated is perpetuating an inverted yield curve, which may be potentially unsustainable long-term for the banking system. While they can provide unlimited capital to help banks survive, these emergency loans compress profit margins for banks. Given the Fed’s comments that no rate cuts are planned for 2023, we expect more pain to surface. However, the Fed may be pushed into some cuts during the second half of 2023 to stabilize the situation.