BY BRIAN GRAHAM
The first half of 2023 has been chaotic for the banking industry: a spate of bank failures, fundamental restructuring of the deposit markets, looming commercial real estate (CRE) credit concerns and impending regulatory tightening all raise big challenges. First quarter earnings provided a critical window into an industry under intense stress. It never pays to be in the prediction business, but with JPMorgan Chase set to kick off second quarter earnings for banks on July 14, it is time once again to flag what we should expect, and can potentially learn, as banks of all sizes disclose their financial performance during yet another stressful quarter.
Interest rates continue to hit the sector. Both the one- and ten-year Treasury rates increased during the second quarter, reflecting in part continued tightening by the Federal Reserve. Higher rates translate into higher levels of unrealized bond losses (and, for banks with long-term fixed rate loans, similar loan challenges). The fact that the yield curve remains inverted (i.e. short-term U.S. Treasury bonds offer higher yields than long-term bonds) is also bad for banks.
Biggest banks remain relatively well positioned. Unlike all smaller banks, the largest banks in the U.S. have not been permitted to “add back” unrealized bond losses when calculating regulatory capital; as a result, they generally managed their interest rate risk exposure and escaped the worst of the losses that are plaguing regional and community banks. Plus these behemoths benefit from the market perception that, since they are too big to fail, uninsured depositors benefit from an implicit backstop that keeps their funding costs low compared to smaller banks. This relatively positive outlook for the biggest banks is underscored by the recent release of generally positive results of regulatory stress tests applicable only to these firms.
Few banks are on the cusp of failure. Both SVB and First Republic were economically insolvent when adjusting for their unrealized interest rate driven bond and loan losses. Many other banks face significant unrealized hits that have not yet worked their way through the regulatory capital calculations. The good news, though, is that very few of those banks appear to be insolvent on an economic basis, even when potential commercial real estate losses are factored in as well. This suggests banks will need very large incremental capital infusions, but that we will see fewer future bank failures than some would expect based on past crises.
Uninsured deposits continue to fall. Uninsured deposits fell by about $550 billion in the first quarter and that trend likely accelerated through June. The SVB failure and uncertainty triggered a flight to quality among stewards of larger deposit balances such as corporate treasurers, not-for-profits, endowments and wealth managers. These accounts have shifted funds into reciprocal deposits (which utilize a deposit insurance network to provide larger accounts with full coverage) and sweep accounts (which move balances above the insurance cap into government money market mutual funds and similar instruments).
High level Federal Reserve and mutual fund industry data suggest overall bank deposits fell by about $200 billion in the second quarter while government money market fund balances grew by a comparable $165 billion, likely reflecting the continuing shift towards sweep structures. We don’t yet have visibility into the shift to reciprocal deposits but, given the opportunity they offer to simultaneously earn a higher yield and gain full and explicit government backing, it is likely that a sizable amount of uninsured deposits also shifted into the insured category during the quarter.
An interesting side note will be the effect of shifts in the balance of uninsured deposits on the FDIC special assessment to recoup insurance fund losses incurred in resolving SVB, Signature and First Republic. The FDIC plans to charge an extra fee on uninsured deposit balances in excess of $5 billion at any bank with calculations based on the level of uninsured deposits at year-end 2022. Any shortfall in the balance of uninsured deposits, some amount of which is a near certainty, implies that the special assessment will not raise enough money for the FDIC. Watch this space carefully.
Funding costs rise more than expected, particularly for regional banks. A drop in uninsured deposits does not create a liquidity crunch for economically solvent banks that have access to a wide array of alternative funding sources including brokered deposits, Fed Funds, the Federal Home Loan Bank advances, and the Federal Reserve discount window. The challenge is that all alternative sources of funding cost more - hundreds of basis points more - than non interest-bearing accounts that they may be replacing. We have already seen a number of larger regional banks repeatedly revise earnings guidance downward to reflect ever higher funding costs. Further negative surprises are likely.
Loan growth is anemic. Banks tend to cut back on lending when under stress, and this cycle will be no different. Loan growth on average will prove anemic. This expectation is bolstered by high level Federal Reserve data which points to annualized loan growth of only about 4%.
Net interest income disappoints, particularly among regional banks. The combination of higher funding costs and anemic loan growth will be very weak net interest income.
Commercial Real Estate (CRE) remains unquantifiable. Banks face CRE losses, but whatever the ultimate level of the industry’s CRE losses, they will not be evenly distributed over the industry. Concentrations by geography and property type, which are inevitable for regional and community banks, will lead some banks to face minimal losses while others will be hit hard. Second quarter earnings will offer a few tidbits related to CRE, but the real insights into CRE will not emerge until the end of the year or early 2024.
First glimpses of the impact of regulatory tightening appear. Every bank crisis triggers political and regulatory reactions. While explicit, broadly-applicable regulation impacting how banks might be forced to recognize embedded losses is important, the bulk of regulatory pressure will happen through bank-by-bank supervisory discussions. Therefore, the best measures of whether that pressure is being applied to a given bank will be commentary on potential action steps that trigger crystallization of unrealized losses: M&A, asset sales, loan growth and capital raises. Many of those action steps require banks to raise incremental capital and, as a consequence, are unlikely to be broadly visible in second quarter earnings; like CRE exposure, the rocks will likely begin to roll down the hill toward the end of 2023.