It has been nine months since the spectacular and sudden collapse of Silicon Valley Bank. After witnessing three of the four largest bank failures of all time in 2023, the attention of the media and the markets has turned elsewhere. Banking crisis? It is as though it never happened. Having fallen by some forty percent in March, the NASDAQ Bank Index has recovered to within fifteen percent of its high from February. In the last few months, nearly all markets have gone on a bull run, including bank stocks. Yet, and despite the relative quiet, the banking sector is not in great shape. Here are some of the reasons why.
Banks continue to lose deposits. According to FDIC data, U.S. banks have now lost deposits for six consecutive quarters. While the pace has slowed from the first quarter of 2023, in which nearly half a trillion of deposits were removed from the banking system, approximately $190 billion of deposits have been withdrawn in the last two quarters. Indeed, U.S. banks have lost a net $1.1 trillion of deposits since the beginning of 2022 when interest rates began to rise.
With customer deposits growing scarce, U.S. banks are instead relying on emergency funding lines from the Federal Reserve Banks and the Federal Home Loan Bank (FHLB) system. FHLB bond capital raising (proceeds are used to fund the banks) is up 89 percent year-over-year through November and looks set to reach $1.1 trillion for 2023. Use of the Bank Term Funding Program, the emergency line put in place by the Fed in March 2023, reached an all-time high last week at $131.3 billion. This does not reflect normal market operations. This is a sign that the bank funding markets aren’t operating properly, and that the regulators are stepping in to help prop up the system.
So much for the liabilities side. But banks face challenges on the asset side as well. Unrealized losses on investment securities, which is the same problem that got SVB into trouble a year ago, continue to rise. U.S. banks reported unrealized losses of over $684 billion in the third quarter, up 22 percent from the second quarter. Of these unrealized losses on securities, $294 billion are categorized as Available for Sale (AFS), as opposed to Held to Maturity (HTM) where the bank intends to hold the asset and (hopefully) recapture principle at the end of the term. The high amount of AFS suggests that if interest rates remain “higher for longer,” then a portion of these losses will begin to realize in 2024 as they are sold by the banks. This will pressure profitability and capital levels.
Net income is declining across the banking system generally, but particularly amongst the smaller community banks. Credit quality is deteriorating, but not yet to crisis level. Commercial real estate continues to drive the increase in problem loans.
To grow (or at least slow the decline) of deposits, banks are going to have offer rates that are somewhat competitive with money market funds (considering that bank deposits are insured by the FDIC and thus relatively safe), and that offer positive real (i.e., after inflation) returns. With inflation persisting in the three to four percent range, this means that banks will have to offer four to five percent to be relevant. This isn’t going to work for the banks. They won’t be able to maintain profitability. And it won’t work for the U.S. Treasury, which itself is committed to trillion dollar bond issuances each quarter, which also must offer a positive interest rate above investor perceptions of inflation and the deteriorating fiscal condition of the U.S. government.
If funding costs rise further, or if unrealized losses begin to realize, banks will start taking hits to their capital levels. This will spook the markets, including depositors, and we may find ourselves in round two of deposit runs. To head off these challenges, some banks are looking to merge. There have been 78 bank deals announced in the second half of 2023, mostly among the smaller and community banks. But this won’t work in many situations where the result is the proverbial “two drunks holding each other up.”
Investor optimism is permeating markets going into year end, with most all asset classes continuing to rise. But we must not lose sight of the banks. They are not out of the woods yet. While there is a “goldilocks” scenario in which the banking sector makes a soft landing, the risk of another set of bank failures in 2024 remains meaningful.
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