ACTV - The Banking Crisis Is Over: Beware What Comes Next

2023-03-30 08:45:00 ET

Summary

• Media reports of dramatic bank runs have receded.
• Without dramatic reports of bank runs or bank failures, needed reforms are unlikely.
• The problems in the US banking system will persist outside of the public view. They're likely to cause very serious problems in the US economy if not addressed.
• This article analyzes, in detail, problems in the US banking system and risks to the overall US economy.
• Risk of recession in the US in 2023 is increasing substantially.

Dramatic headlines about bank runs are no longer dominating the financial news. That would seem to be good news for the US economy. But, is it really?

In this article, we will show that just because the problems in the banking system are no longer making headlines does not imply that you should be lulled into thinking that very serious problems are not developing outside of public view. The problems that are developing are, indeed, very large. But, at least for now, they will most likely “slow boil” outside of the public consciousness until larger problems emerge, perhaps later this year.

The Underlying Problems in the US Banking System Have Not Been Solved

In my article, “ Banking Crisis: A Primer for Immediate Action ,” I outlined various key problems affecting the US banking system in considerable detail. Below, I will provide a highly compressed summary of some of the causes of current banking sector problems:

Massive growth of excess liquidity. The combination of a massive fiscal spending binge and a massive expansion of the US money supply (in the immediate aftermath of the COVID epidemic), has created an unprecedented amount of excess liquidity in the US banking system. In particular, businesses and wealthy individuals have larger cash balances relative to their overall balance sheets and income than ever before. These excess cash balances have been largely deposited at US banks, as can be seen below.

Demand deposits alone have increased by two-and-one-half times since 2020. Faced with unprecedented amounts of liquidity and extremely low short-term interest rates, US banks have essentially been incentivized to make imprudent investments. In search of yield, banks extended their maturity profiles (increase risk of maturity mismatch) and increased the risk profile of their overall lending and investment practices.

Excess liquidity has created a toxic mixture. On the one hand, the massive increase in near-zero-maturity deposits increased the risk of withdrawals by depositors that are the owners of this excess liquidity – particularly large depositors. This increased risks on the liability side of banks’ portfolios. At the same time, in their search for yield in a world of ZIRP and QE, banks increased risks (maturity and credit) on the asset side of their portfolios.

Disproportionate growth of uninsured deposits. The massive growth in deposits described above was disproportionately concentrated in large and uninsured deposits. While insured deposits of less than $250,000 grew relatively modestly, uninsured deposits greater than $250,000 increased at an extremely fast pace. As a result, uninsured deposits as a proportion of total deposits at US banks grew from roughly 44% at the end of 2019 to a peak of over 49% at the end of 2021. This has merely exacerbated an ongoing long-term trend that has been in place for many years. For example, uninsured deposits as a percent of total deposits were 21% at the end of 2010. Therefore, the problems and risks posed by uninsured deposits are currently almost two-and-one-half times as large as they were at the end of 2010.

Increasing ease of deposit withdrawal. Stating that the problems and risks posed by uninsured deposits have multiplied by almost two-and-a-half times understates the issue. The problem is not merely that banks have greater proportions of uninsured deposits as part of their funding mix. The problem is exacerbated by the fact that this particular funding source has become inherently less dependable. Various financial innovations, including technological inventions and the development of new cash management alternatives, have made it easier and more attractive than ever for large uninsured depositors to withdraw their funds from banks at the slightest hint of risk or inconvenience. This is an ongoing secular development, which was simply highlighted by recent runs by large depositors on various US banks.

Technological and cultural change . Formerly, the treasurers of US companies and wealthy individuals had very few choices for how they could manage their cash assets. Unless they were prepared to store their cash in private vaults, large depositors had to rely on banks to safeguard and otherwise manage their cash. Today, cash management options have greatly expanded. For example, it's far easier today than ever before for corporations to move funds around instantaneously between money market funds, interest-bearing bank accounts, and demand deposit accounts at institutions all over the US. Crypto exchanges and stablecoins have emerged as an alternative way to move cash around even more rapidly and more continuously (24/7) than via traditional financial institutions. It also has become far easier for US non-financial institutions to manage their own liquid funds via direct management of US Treasury Securities such as T-Bills.

Cultural changes are accelerating behavioral changes enabled by financial innovations. US companies and individuals have become more financially savvy and culturally prone to active management of financial assets. The cultural push to “scalp” a few basis points of yield is increasingly eclipsing old-school “relationship banking.”

Banks could formerly count on more stable depositor behavior when they had more value to offer their clients. Today, disintermediation is occurring, in part because banks are able to offer relatively less value than their clients can accomplish on their own managing their cash funds in a highly discretionary manner.

In sum, from the above discussion, it should be clear that the key causes of recent US banking problems have not been addressed. Furthermore, it also should be clear that some of the problems faced by the US banking system are actually secular trends that are going to continue - to varying extents and at varying speeds - regardless of any solutions adopted to contain the current banking crisis.

Without Dramatic Bank Runs, the Problems are Being Left to Linger

There's only one decisive and effective way to address - at least partly - the long-term systemic problems and secular tendencies discussed in the previous section: A credible deposit insurance system that covers 100% of US bank deposits.

Developing such an insurance system, getting it to pass through both legislative bodies of the US Congress, and implementing it via a new regulatory regime is a massive undertaking. It would represent a veritable revolution in the US financial system and the legal-regulatory system that supervises it.

The problem is that without a major crisis, the incentives and the sense of urgency will likely not be sufficient to overcome the massive obstacles and inertia that exist.

Without the implementation of effective long-term solutions, the problems in the US banking system will linger. The external bleeding and the internal bleeding will continue. However, the politicians and the general public will not be aware of it.

External Bleeding Has Slowed but Internal Bleeding Continues

By “external bleeding”, I mean loss of deposits, particularly uninsured deposits. All but the largest and most trusted banks will be subject to this sort of bleeding going forward.

By "internal bleeding”, I mean the consequences of loss of deposit funding and/or rise in funding costs. Banks that have lost deposits will suffer from reduced funding, higher funding costs, lower net interest margins, and consequent lower profitability.

The external and internal bleeding will have the following consequences at affected banks:

1. Need to deleverage. In order to buttress their liquidity and capitalization ratios, banks will deleverage by reducing the amount of credit that they carry on their balance sheets.

2. Restrict credit growth. Even banks that do not deleverage will tend to restrict new credit growth. This is particularly true of more risky lines of business, such as small business loans, real estate development, and unsecured consumer lending (e.g. credit cards). This type of lending is particularly vital to the US economy.

3. Banks will seek safety. This will mean lowering the maturity profile of their credits and lowering the risk profile of their credits. First, lowering the maturity profile of credit will mean that long-term lending for long-term investment will be curtailed. Adjustable-rate lending will increase, which will tend to crimp many long-term investment projects that cannot risk changing interest rates. Second, lowering the risk profile of bank credit portfolios will mean that lending that was formerly available for certain types of projects and businesses will tend to disappear.

4. Raise credit standards. Raising credit standards is a way of lowering the risk profile of the loan portfolio and also is a way to slow growth and/or deleverage a portfolio. The bottom line is that banks that are affected by reduced access to funding and/or higher costs of funding will tend to raise lending standards, which will make it more difficult for customers to obtain credit.

5. Raise the cost of lending to customers. For those customers who qualify for loans, the cost of lending will tend to rise. Furthermore, various other terms will be less favorable, effectively raising the cost of borrowing. Maturities will shorten, collateral requirements will increase, covenants will be stricter, and so forth.

It's very important to understand that just because banks are no longer failing (such as occurred with Silvergate ( SI ), Signature Bank ((SBNY)), and Silicon Valley Bank ((SIVB)) does not mean that all is well in the banking world. Perhaps one-third or more of US banks are suffering from deposit losses and an increase in funding costs. This will have a very real impact on the provision of credit to businesses and consumers - particularly in certain market segments and certain regions - thereby significantly impacting economic growth in the US.

Many Deposits that Left Are not Coming Back

There are systemic reasons why deposits will tend to fall in the US. First, reduction of excess liquidity is a process that will need to continue for many years in the US in order to contain inflation. This implies a system-wide reduction in deposits, as has occurred since the start of QT. Second, many large depositors will likely change cash management practices permanently in favor of money market funds and/or holding T-bills directly. Therefore, for both of these reasons, it's very likely that total deposits in the US banking system will tend to contract or flat line.

However, even if we assume that this is not the case and total deposits in the US recover to former highs, without a revolution in deposit insurance, it's highly likely that deposits will be redistributed in a way that adversely impacts many banks. Affected regional and niche banks are unlikely to recover a large portion of the large uninsured deposits that they have lost.

It makes very little sense for large uninsured depositors to manage their cash at banks where there is even a 1% risk of having their funds seized temporarily and where they could suffer a haircut to their deposits. Customers with large amounts of excess cash to manage simply have too many less-risky (and potentially even more lucrative) alternatives. Many of these large customers will not be lured back into old and complacent relationships with their old banks.

The Credit Crunch Will be Sectoral and Regional

Larger and more diversified national banks stand to potentially gain deposits that flee from smaller, regional, and less-diversified banks. In this regard, it's very important to understand that in this process of redistribution of deposits, the larger, national, and more diversified banks that gain deposits are not going to entirely replace the credit retrenchment by the regional and niche banks that have lost deposits. Large national banks are not going to step in and fully replace lending in communities, regions, and in specialized economic niches that are currently served by smaller banks.

It should be noted that small/medium banks account for 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.

If these smaller, regional, and niche banks retrench their lending activities to the communities and economic sectors they serve, economic growth in the US will be severely impacted.

The Problems May Not Be Dramatic Enough to Elicit Real Solutions

As stated earlier, without a radical overhaul of the current deposit insurance system and the accompanying regulatory structure, the external and internal bleeding at many US banks will likely continue. Unfortunately, the type of “bleeding” that will be ongoing will not be visible enough nor dramatic enough to elicit the type of radical action that is needed.

Without further dramatic bank runs, the banking industry and Congress will likely not act in a timely and decisive manner.

This is why I suggest ironically in the title of this article that the absence of dramatic bank runs may not be as good of a thing as it seems.

Lower Interest Rates Alone Will Not Solve the Problem

Many people seem to be under the impression that the problems in the banking system can be solved by the Fed lowering interest rates. This is false. Lowering interest rates might help a little bit in the short term. But in the long term, the key problems will linger, and perhaps get worse.

Lowering interest rates does nothing to protect uninsured depositors. It does nothing to change the incentives of large depositors. It does nothing to reduce the ease with which large depositors can withdraw deposits.

To the contrary, excessively low interest rates can aggravate the problems in the US banking system. Indeed, excessively low interest rates, combined with an excessive expansion of the money supply, were a major cause of the current banking problems. First, low interest rates increase inflation risks. Higher long-term inflation is a potential killer of the US financial system. If long-term inflation expectations rise, long-term yields on assets will rise, creating massive losses for US banks. Second, as we have already seen, the combination of low short-term interest rates and excess liquidity can cause higher systemic banking risks by encouraging maturity mismatches and otherwise imprudent lending practices.

The fact of the matter is that excessively low short-term interest rates will perpetuate existing problems in the US banking system and will substantially raise the risk of more catastrophic problems such as a rise in long-term inflation expectations. A related major risk would be a loss of confidence in US dollar-denominated assets (especially US Treasury securities) and the US dollar itself.

Negative real short-term interest rates are not a cure. They are, in fact, a slow-acting poison that increases risk in the US financial system.

Risk of a Credit-Led Recession is Rising

Let us forget about potentially catastrophic future risks, for a moment. The fact of the matter is that, as things stand right now, an enormous percentage of US banks have lost deposits and/or have had their cost of funding increased. As explained in this article, this is going to cause a retrenchment of lending and lending growth in many market segments and regions of the US that are absolutely critical to the overall economy.

I see very few scenarios, other than a radical overhaul of the US deposit insurance system, that will prevent the sort of selective credit retrenchment described in this article.

As a result of these very real ongoing developments, the risk of a credit-led recession in the US is rising. Whether or not such a recession will occur, and the potential severity of such a recession, will depend on the extent of the selective credit retrenchment process that was described earlier.

I do not think that there's any doubt that credit retrenchment is currently occurring. And I have little doubt that credit growth going forward will slow significantly. However, the extent of credit retrenchment is still very much an open question. More data and careful observation will be required to enable a confident assessment regarding the probability of a credit-led recession and its potential severity.

Final Thoughts on Portfolio Strategy

Investors and traders should not be lulled into a sense of complacency by the fact that news headlines are no longer filled with dramatic stories about bank runs. If you look closely at what's going on, there are very serious problems in the US banking sector that persist and which are likely to create major challenges for the US economy going forward.

We do not currently have a high level of conviction regarding how significant the credit retrenchment will be for the remainder of 2023. However, because of our expertise in this area, we believe our team is very well positioned to stay out in front of whatever trends happen to emerge in the next few months - be they bearish or better than feared.

More generally, at Successful Portfolio Strategy, we're very focused on the short-term, intermediate-term, and long-term impacts of revolutionary changes that are occurring in the US and global banking system. These changes are going to present enormous risks to everybody’s portfolios in the next few months and years but also will present enormous opportunities. Our team has a system in place which constantly assesses macro risks of various sorts, including their impacts on recession probabilities, for purposes of guiding our asset allocation and finding specific opportunities around the world that arise due to prevailing macro conditions.

In our portfolios, we're currently very focused on limiting overall risk exposures and in identifying low-risk and high-reward opportunities that we expect will exhibit relatively low correlations to the overall US equity market.

With macroeconomic outcomes as uncertain as they currently are and with the S&P 500 currently straddling the middle of a wide trading range that's roughly between 4330 and 3760, the reward-to-risk ratio of investments that is highly correlated to the S&P 500 is currently relatively unattractive. We think that now is a time to be more patient than usual as well as relatively unconventional in the search for relatively uncorrelated investment opportunities.

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