How Did Banks Get Here?
By Michael McKeown, CFA, CPA - Chief Investment Officer
There is a lot to the story, but let’s keep it simple.
Fiscal stimulus during COVID helped avoid an economic depression. Much of the stimulus found its way to banks in the form of deposits by businesses and individuals. This consequence of low rates and stimulus stoked the fire that led to today’s high rate of inflation.
To fight inflation, the Fed raised rates at the second fastest pace since 1970 and when interest rates rise, bond portfolios fall in price.
Under these circumstances, the loans and bonds that banks acquired at previously low rates are on their books as an unrealized loss. Even though the principal will be paid back on treasury and agency mortgages, there is a temporary decline in price when rates rise. As borrowers defaulted in 2008, the principals due on subprime loans were not going to be paid back. Thankfully, that’s not the situation we face today.
To make a spread and increase earnings, banks pay a lower deposit rate than they charge for a loan. As the Fed raised interest rates, Treasury bills and money market funds paid more than bank deposits, leading to deposits leaving banks for Treasury bills and money market funds.
This is a new development in the history of banking. Deposits declined by nearly 6% from a year ago.
Silicon Valley Bank (SVB) and Signature Bank experienced a classic run, where depositors pulled funds after learning about the banks’ shaky balance sheets. To tamp down any potential for broader panic, the Fed and Treasury guaranteed that all deposits, even those exceeding the $250,000 FDIC limit, would be safe. Last week, Chairman Powell, trying to further ease any sense of panic, said “all depositors are safe,” even though it’s the Treasury and Congress that have the power to make that guarantee. The authorities will always do what they feel is necessary to prevent financial contagion, so we take him at his word.
According to reports, executives at SVB and other executives lobbied Congress to ease regulations on banks, including liquidity and capital requirements. This increased the threshold to $250 billion for tougher stress tests, which both SVB and Signature Bank fell below. In hindsight, the tests could have been valuable to regulators and investors.
Over the past year, late loan payments increased from low absolute levels. Lenders are already near recession levels in terms of tightening credit. With deposit outflow risk, and having just seen two major domestic banks fail, credit is likely to continue becoming scarcer and more expensive.
The Federal Reserve raised interest rates to 5% last week. Chairman Powell remains focused on the fight against inflation while trying to protect the stability of the financial system.
The bond market changed its path with respect to interest rate hikes. A month ago, higher rates were expected into 2024. Now, the yield curve suggests interest rate cuts are ahead. The Fed has only noted that, for 2023, “some additional policy firming may be appropriate.” The path they ultimately choose will depend on how embedded inflation proves to be and their read on overall financial stability.
For now, short-term cash can earn a decent return in Treasury bills, Certificates of Deposits (CDs), and money market funds. It seems we are only in the early stages of the financial sector’s adaptation to higher interest rates. From what we’ve seen so far, it appears industries and businesses relying on debt will face a challenging financing environment ahead. The good news is that by raising interest rates, the Federal Reserve has created room to cut interest rates when an economic slowdown happens.
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