Revisiting the Banking Sector

Telemus Weekly Market Review June 19th - June 23rd, 2023

It’s been a little over three months since the failures of Silicon Valley Bank (SVB) and Signature Bank. We felt it an opportune time to revisit that status of the U.S. banking system and its stability. 

The challenges that banks faced in March were largely a function of rising interest rates and nuanced accounting conventions, fueled by the impact that the digital economy had on depositor behavior.  More specifically banks were incurring temporary losses on their investment security holdings (bonds) given that the sharp rise in rates led to price reductions in bond prices. Should these bonds be held to maturity, the price movements would have worked themselves out. However, as deposit withdrawal requests accelerated, some banks were forced to sell bonds and realize the losses, instead of holding them to maturity as initially planned. The broad use of online banking tools that allowed for the easy transfer of funds along with the ability to spread rumors and concerns via social media led to a different and more immediate style of bank run. 

During March’s mini banking crisis, the Federal Reserve put in place a mechanism to help banks manage any additional liquidity challenges. The Bank Term Funding Program was initiated to provide loans to banks in exchange for the banks pledging their investment securities as collateral. The nuance of this program is that the Fed would lend up to the par value of the bond (or the value of the bond at maturity), which provided a source of funding for banks that might be forced to liquidate bonds trading at a discount to their maturity value. This was a notable program as it provides an alternative for banks that might otherwise be forced to sell securities that are temporarily trading below their par value. 

Bank management teams have responded to March’s mini banking crisis by bolstering their liquidity position. This has meant becoming more stringent with their lending standards and ultimately reducing the amount of new loans issued. Banks are also holding more deposits in liquid short-dated investment securities. They have also looked to alternative funding sources so that they are less dependent on traditional checking and savings deposits. These would include issuing more certificates of deposits with stated maturities, issuing bonds, and obtaining funding from the Federal Home Loan Bank (FHLB). The FHLB provides funds collateralized against a bank’s mortgages or mortgage-backed securities. Collectively, all these measures should help to add stability to the balance sheets of banks. However, in an of themselves, they can’t guard against a bank run. 

A byproduct of these actions is that bank profitability is likely to decline. Reducing the amount of loans is likely to result in lower interest income and sourcing funds from broader funding sources should lead to higher interest expense. Furthermore, the attention around bank liquidity has prompted many depositors to not only consider whether they have sufficient FDIC insurance coverage but to also ensure they are getting competitive yields on their deposits. This has resulted in a sharp rise in deposit rates, with the FDIC reporting the average bank experienced nearly a half of a percent increase in deposit costs during the first quarterⁱ.  In addition, over time we’d expect added compliance costs and higher FDIC insurance assessments on banks, raising their operating expenses. Bank stock valuations have begun to reflect the expectation of lower profitability but given the actions that have been taken it’s hard to categorically become excited about the near-term upside for the sector as a whole. 

An emerging challenge for banks is the deterioration in the commercial real estate, and the office sector in particular. In many urban centers, office buildings remain only 50% occupied. This is lowering demand and challenging rents. Given that banks have been large lenders to the office sector, concerns have grown on how the coming demise to the office real estate sector will impact banks. Some concerns are on the ‘wall of maturities’ among commercial office space. While there is a higher than average amount of maturing debt on office buildings in 2023 and 2024, a greater share of that is tied to bond based funding in the form of commercial mortgage backed securities. In fact, the amount of maturing office debt on bank balance sheets is steady for the next several years. That doesn’t stop the pain, but it provides a balanced cadence of maturities over the next several years. 

While there are elevated concerns around bank exposure to office real estate, its important to note that not all banks have the same amount or types of exposure. Moreover, banks have diverse loan portfolios and generally office real estate does not make up a large portion of most banks’ loan exposure. Furthermore, overall credit conditions remain very strong with less than 1% of their total loans more than 90 days past due, on average1. 

For many investors, it may seem like the banking challenges of March are behind us. We are hopeful this is the case, although we remain guarded as the underlying factors that led to SVB and Signature Bank’s ultimate demise have not gone away. The actions that the Federal Reserve and bank management teams have taken have helped to ease the worry and provide added supports should such an episode occur again. 

However, our advice today is consistent with our guidance in the second half of March. First, consider separating your transactional cash from savings that you don’t intend to use in the short-term. The later bucket may be better suited in higher yielding deposit products or government backed solutions like Treasury bonds, a government money market fund, or ultra-short term Treasury mutual fund or EFT. Second, if at all possible, ensure you don’t hold more than $250,000 of deposits with any single financial institution. Should you need coverage from multiple institutions, we have solutions that can help with that. Finally, use the opportunity to ensure you are earning competitive yields on your non-transactional cash. Depending on the cash management solution, yields are presently in the 4% to 5% range, but will change over time.  

ⁱFDIC Quarterly Banking Profile. First Quarter 2023. https://www.fdic.gov/analysis/quarterly-banking-profile/qbp/2023mar/qbp.pdf#page=1

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