My Concerns Around Banking

2023.03.20, Jeffrey L. Stock, CFA, MBA

I think banks have a problem.  The World has a lot of highly educated, well informed people to work on the problems. Despite this, I think there is reason for caution.

First- a simple refresher on how they make the their money. Banks make money from the interest on their loans and investments.  This is interest income. Banks borrow money from depositors in checking accounts, CDs, savings accounts, etc.  They pay interest to on deposits as necessary to keep the deposits.  This is interest expense to a bank (and income to depositors). 

So a bank makes money on the difference between what it earns in interest on loans and what it pays to depositors.  To be clear- these are not the only ways banks make money, but this is the basic framework for banking. The current Fed Funds rate (to which many money markets correspond) is currently (as of the time of this writing) 4.5%.  This means that banks would need to pay approximately 4.5% to borrow money from each other or the federal reserve (should they need it).  For customers paying attention, this is an approximation for the rate their deposits would earn in money markets instead of 0 (what many banks are paying on core deposits).  My concern is that if banks don't pay more interest on deposits (and instead leave them near 0), then deposits will gradually move in to short term government bonds and/or money market where there is significantly higher interest.  Based on 2022 Year End publications from the FFIEC (Federal Financial Institutions Examination Council), we have seen that the largest banks (Insured corporations with over $5Billion in assets- which is the group to which this post will refer) are not paying particularly much on their deposit base:

50% of banks in this group were only paying between .26% and .69% to retain deposits (based on FFIEC- UBPR data from 2022-12-31). This is not very high in light of developments even to that time.

Banks MAKE money on their loans.  Information is available on the same group that shows how much banks were earning as of 2022/12/31.

The chart above shows that most banks are only earning between 3.25 and 4% on their assets- well below 4.5%. Two things of note about this: 1. As loans renew, banks will increase the amount they are charging in interest and 2. Deposits are "sticky" and not likely to "flee" because of lack of interest- but there would likely be a trickle leaving, gradually turning in to a stream if short term treasury rates don’t fall. I am concerned depositors are likely to shift away over time if the banks don’t start paying more in interest- and that will squeeze bank profitability.

To get the cash to give these depositors- who are likely seeking the highest interest rate they can get on their money- a bank would have to either accept new deposits or sell off securities from their investment base. A bank will continuously adjust investments to better meet liquidity requirements so that depositors can get money if needed. A problem arises from this- some of the investments are not shown at market value- they are higher on the books than what the bank would receive if sold. Those investments have gone down as interest rates have gone up over the past year. If a bank sells enough holdings at a loss (losses that had not previously been accounted for) they may have to raise more equity to satisfy regulators. This is a potentially large problem. Banks voluntarily report this potential loss in their quarterly UBPR report (again- from the FFIEC). I am surprised at the negative impact for the banks that are reporting. The following chart reflects the biggest adjustments to equity (as a percent of equity) if just the securities of each bank were shown at their market price. As you can see- there is some cause for concern.

Names now common in the financial press (like Silicon Valley Bank and First Republic) are not the worst offenders of this. I am also concerned about the size of some of these losses. For example- 48% of Bank of America’s Equity Capital is a MUCH larger number than 98% of Silicon Valley Bank’s Equity Capital. Despite the concern this creates, we have to keep in mind that these numbers are only relevant in the event the banks have to liquidate VERY large portions of their securities. Also, I believe it is most likely that additional measures would be implemented by the FDIC, US Treasury and Federal Reserve as (or before) those liquidations would occur. While I am very diligently working to assess the situation and risks posed, there are many people (much smarter than me and with better information) working to manage those risks, quell investor/depositor fear and work out a solution that keeps the US banking system operating and strong.

We continuously research, assess risks (to the best of our ability) and strive to be wise in a tricky environment.

All data is sourced from the FFIEC (Federal Financial Institutions Examination Council) and their publications of the 2022-12-31 Uniform Bank Performance Reports (UBPR) which can be obtained in bulk or individually from https://cdr.ffiec.gov/public/ManageFacsimiles.aspx. We used a bulk download of all insured institutions with $5B or more in assets.

This material is provided as a courtesy and for educational purposes only.  Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.

All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.  All economic and performance data is historical and not indicative of future results.  All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.