Flunking Money & Banking 101
On March 13th, the Federal Reserve raised the overnight Fed Funds rate 0.25% to a new range of 4.75%-5.00%. The Fed has now completed one full year of an aggressive tightening monetary policy designed to reduce the level of inflation by slowing the economy. The market is now pricing-in a 88% chance that the Fed raises another 0.25% at their next meeting on May 3rd, after which, the Fed will pause and begin cutting rates as the year progresses and the risk of recession increases:
Fed tightening cycles have historically been associated with economic recessions. This chart shows the Effective Fed Funds rate back to 1954, with recessions highlighted by vertical gray bars:
Another chart highlights the fact that Fed rate hikes can also precipitate other unforeseen problems, such as the recent failures of Silicon Valley Bank (SVB) and Signature Bank on March 10th:
These recent bank failures caused the market to suddenly reassess the risk of investing in regional banks, as shown by the decline of the SPDR S&P Regional Banking ETF versus the SPDR S&P 500 ETF:
The last banking crisis in the U.S. began 16 years ago. The Global Financial Crisis of 2007-09 (GFC) created severe repercussions and market dislocations throughout the financial system. While the causes of the GFC were multifaceted, the banking system played a major role in it by taking on significant risks associated with subprime mortgages and complex financial derivatives. As the housing market cooled in response to Fed rate increases, the value of these securities held by many large banks declined, as mortgage delinquencies and foreclosures increased. Massive asset write-downs ensued, and many large financial institutions such as Merrill Lynch, Bear Stearns, and Wachovia, were taken over by other large banks, while Lehman Brothers went bankrupt.
The GFC was gut-wrenching and fraught with uncertainty as to how it would end. The current banking situation, however, is very different. It is not related to risky derivatives or credit impairments, but rather to lax bank risk management controls around bank liquidity, brought to light by rising interest rates.
SVB management had invested over half its assets in U.S. Treasurys and government-guaranteed mortgage securities in an attempt to earn higher yields. Over 85% of these bonds had maturities of 10 years or more. When interest rates rose starting in 2022, the value of these securities fell (there is an inverse relationship between bond prices and interest rates).
On the liability side of the balance sheet, SVB also had a very high percentage of their deposits ($120 billion) that were uninsured by the Federal Deposit Insurance Corporation (FDIC), with account balances well above the $250,000 insured threshold. Many of these large depositors were part of a homogenous, close-knit group of venture capitalists.
With the slowdown of the tech industry, SVB faced a declining deposit base. When they needed liquidity to fund deposit withdrawals, they were forced to sell some of their securities at a loss of $1.8 billion. They then needed additional capital, which in turn raised concerns about the bank’s solvency. Word of this quickly spread, causing a run on the bank, with depositors heading for the exits. The FDIC announced the closure of the bank on March 10th.
SVB was the 563rd bank failure since 2000, with most of those failures associated with the GFC. Ninety-five percent of those failed banks were acquired by other banks, with $728 billion in deposits assumed by the failed banks’ acquirers. First Citizens BancShares assumed the assets and liabilities of SVB, with certain guarantees from the FDIC.
The authors of my favorite Money & Banking textbook summarize things this way:
The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”
The SVB failure was deemed to pose a systemic risk to the financial system by the Federal Reserve. The Fed announced the creation of the Bank Term Funding Program, a new source of bank liquidity in addition to the Fed’s existing 90-day “Discount Window” bank loans. Under the new program, banks can pledge their government securities at par value (not market value) and receive loans for up to one year.
The use of these Fed liquidity sources by banks over the past three weeks suggests that the banking system has achieved some stability, as credit usage declined $11.4 billion on March 29th from the previous week:
In the meantime, we’ve seen deposit outflows from small and medium-sized banks to the largest banks, as well as a significant acceleration of deposits leaving the banking system altogether:
One reason depositors can move their funds so quickly has been the increased use of mobile online banking services:
Money market fund assets, in turn, have jumped in the past two weeks:
This is not surprising, since banks have paid very little interest on their deposits for many years, given the excess liquidity in the financial system (including all the Pandemic stimulus checks). Money market mutual funds, on the other hand, pay market rates of interest (after fees) that have increased in lockstep with the Fed Funds increases. Some money market funds invest solely in U.S. Treasury securities.
In summary, a recent Capital Group research piece wrote “We’ve been here before. This is an old-fashioned bank run. It’s going to be messy, and it’s going to take a while to sort things out. But I think we are well positioned to get through it.”
There can be little doubt that the SVB failure will put regional and community banks under greater regulatory scrutiny. Noting that banks with less than $250 billion in assets have been exempt from such regulations, Capital Group expects to see “higher capital and liquidity requirements, periodic stress testing and restrictions on the types of investments banks can employ in their bond portfolios.”
Banks are also feeling earnings pressure due to the steeply inverted yield curve, since they fund their longer-term lending with short-term liabilities. This can create compression of the normal margin of the interest banks pay depositors versus the interest they earn on loans, which is the driver of bank earnings. More regulation will put more pressure on earnings over time.
One last point: A lesson for consumers is to ensure that their bank savings deposits are earning at rates closer to market levels, while also being aware that amounts on deposit do not exceed the FDIC insurance guarantee.
John Finley, CFA, serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.
847-441-5644 | firstname.lastname@example.org
We value your comments and opinions, but due to regulatory restrictions, we cannot accept comments directly onto our blog. We welcome your comments via e-mail and look forward to hearing from you.
All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness. This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client. The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment. Those seeking information regarding their particular investment needs should contact a financial professional. Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material. The opinions expressed were current as of the date of posting but are subject to change without notice due to market, political, or economic conditions. All investments involve risk, including loss of principal. Past performance is not a guarantee of future results.
Copyright © 2023 Coyle Financial Counsel. All rights reserved.
 Email received 3/20/23 from Jim Reid of DB Research
 Email from Matt Topley dated 4/4/23