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Our CIO and bank analysts consider changes that may be coming for banks in the wake of recent events.
Confidence, the bedrock of a functioning financial system, was tested in early March as news of bank failures and questions about liquidity shook depositors and investors. Here are our expectations for the sector.
A rush for safety continues
It is relatively easy to move assets to a large money center bank in the digital/mobile age, and in the current environment, many depositors and CFOs perceive them to be less risky. Though it is unnecessary, in the short term, we would not be surprised to see deposits move from the regionals to larger banks. The U.S. government may not like too-big-to-fail financial institutions, but the market is heading in that direction and the big will become bigger. That doesn’t mean everything is necessarily rosy for the big banks. While they may be raking in deposits, they’ll also be on the hook to fund that deposit insurance. (The FDIC is not funded by taxpayers; banks and savings associations pay into the FDIC insurance fund in proportion to their size.)
Regionals get reregulated
In 2018, Congress exempted small banks from the regulatory scrutiny that the big banks still face, such as the Fed’s annual CCAR1 bank stress tests. We expect this to be reimplemented.
The tests, which assess whether a bank has the strength to weather large losses, are likely to be applied more broadly to regional banks, as regulators acknowledge that even banks that are not the largest can still destabilize the financial sector. Capital and liquidity rules that currently only apply to systemically important banks (i.e., large money center, super-regional and trust banks) may also be pushed down to apply to regional banks. This includes total loss absorbing capital rules that require [these larger] banks to issue senior unsecured debt2 as a bulwark against loss and the inclusion of unrealized bond portfolio losses (those deemed available for sale) in the calculation of regulatory capital.
Greater regulation equals increased costs for the regionals. While the application of these rules will likely be phased in over a few years to give the banks sufficient time to comply, they will likely reduce profitability and perhaps bank stocks’ valuations, even while providing investors with more confidence.
We’re also likely to see a larger role for regulators generally as they seek to maintain confidence in the financial system. The brokered takeover of Credit Suisse by UBS is a good example of this, as is the Federal Reserve’s efforts (along with others) intended to stabilize First Republic Bank.
Peak NIM, for this cycle
Net interest income (NII) is the amount of money that a bank earns in interest on loans minus the amount it is paying in interest on deposits. NII drives a bank's profitability. As rates have gone up, banks have been able to boost NII by earning higher yields on loans, while paying depositors less interest on their savings accounts.
Net interest margin (NIM) is NII divided by a bank’s interest earning assets. We think that NIM has probably peaked, as depositors have become aware of options paying higher rates, such as money market mutual funds. A bank that sees deposit outflows will either need to raise its rates or borrow money at higher rates, either way this drives NIM down. However, while NIM may have peaked, it is possible that NII has not, as some banks’ assets will rise more than NIM falls. The net-net for investors is that bank earnings and valuation may be impacted.
During the great financial crisis (GFC), one common tool for regulators in resolving a struggling institution was to find a willing buyer (i.e., a strong bank). There are four reasons why this solution is unavailable to the Fed in this environment.
- First, in the GFC, those banks that came to rescue failing banks found that they faced intense regulatory scrutiny after the fact, and concessions granted in the heat of negotiations were not honored.
- Second, under current accounting rules, the buyer must mark to market the acquired balance sheet: loans, securities and deposits alike. Given that all loans and securities were originated or bought at lower rates, these valuations would produce losses for the acquiror, which would hurt the acquiror’s capital ratios. Buyers would want this fact reflected in the acquisition price (i.e., it would be low) discouraging the seller and adding to negative psychology for the value of bank stocks.
- The third reason is that the largest banks are prohibited from getting bigger through acquisition except with regulatory permission.
- Last, the current crisis comes from depositors fleeing banks quite suddenly in large volume, often through online banking and mobile apps. This phenomenon makes it very difficult for regulators to gather acquirors and provide them with the necessary data to make a confident, well-informed decision in a timely manner. Consolidation is unlikely to bail out a bank under pressure.
Ongoing importance of the rate backdrop
It’s only a small subset of banks that are seeing deposits flee, and obviously there are significant implications for those banks from a profitability standpoint — especially if they are backfilling with expensive borrowing or swapping of assets with the new Fed facility. Another subset of banks is worthy of investor attention: those banks that are not seeing any deposits flee, but have a high allocation of “held to maturity” investments and outsized bond losses in their “available for sale” bond portfolios, coupled with other liquidity constraints. We anticipate that many of these banks will seek to rebalance their bond portfolios as quickly as possible, which will mean selling longer duration bonds and buying shorter duration issues.
One catalyst that would bring rapid relief to the bond portfolio situation: lower rates. The Fed’s rapid increases after many years of zero interest rates created liquidity mismatches, and any reduction in rates would take the pressure off and allow banks to shorten their duration. So, by extension, any relief found in the inflation data will eventually translate into a better backdrop for banks.
Continuing social distortion
The speed of Silicon Valley Bank’s collapse was breathtaking — the bank announced its plan to raise capital on March 8, and by March 10, it was seized by the FDIC. More recently, we saw Credit Suisse come under pressure after Saudi National Bank indicated that it would not commit incremental capital to the bank. In both cases, the speed of information on the internet created a “shoot first, ask questions later” environment as CFOs and risk officers sought to limit exposures.
The internet is not going away, so the onus is on banks to have business models that can stand up to internet scrutiny and the motivations of bad actors who may manipulate those platforms. No one has perfect insight into what businesses will come into the crosshairs or when emotion may overwhelm logic. The flip side of this dynamic is that these distortions also create opportunity. The dislocations created by market volatility (especially when driven by emotion) can create buying opportunities for those willing to put in the research. Diving in and doing the analytical work may uncover great opportunity in some cases.
Balancing long-term investments in a short-term-minded market
Banks take in deposits and lend them out to companies that want to expand (e.g., buy equipment and hire employees). In the past, banks could rely on these deposits to remain for years, so they felt comfortable lending money to companies for these long-term investments. Deposit outflows in recent weeks occurred as market participants began to question the valuation of long-term loans and investments that were meant to be held for years, which resulted in concerns over bank viability. Banks need to be able to diligently provide long-term capital to growth-minded borrowers without fear of short-term factors inhibiting their ability to do so. Policymakers should focus on the root causes of how we got here and help figure out a path forward.
1 Comprehensive Capital Analysis and Review
2 First in line to get paid from the assets of a company that goes bankrupt, excluding any pledged assets for secured senior debtholders