Dutch legend has it there was a small boy who, upon passing a dike on his daily walk to school, was puzzled by a slight leak he saw as the sea trickled through a small hole between stones in the wall. Knowing full well he would get in trouble for being late to school, the boy nonetheless poked his finger in the hole to stem the flow of seawater. Sometime later, a passerby saw what the young boy had done, and went to get help from those in the village. Eventually aid came in the form of men who were able to repair the dike by sealing the hole in the wall, averting certain disaster for the entire town. The moral of this once very popular story: acting quickly, even with limited strength and resources, can help avert disaster.
After more than three years of stumbling from one conundrum to the next—the COVID-19 pandemic, Putin and the Russians, the Chinese, inflation/recession, the Federal Reserve, last year’s market meltdown and everything else—we all need a break. Adding to our chagrin, the past couple of weeks have been akin to a big ole’ roundhouse left hook in the 15th round of a prize fight. Unless you haven’t been privy to any news lately, you already know the reasons for the most recent and warranted angst. To us normal, everyday-type folks, it appears the global banking system is standing on wobbly legs and getting ready to be knocked out. First, it was the failure of cryptocurrency darling Silvergate Bank. Next it was another California bank, the much ballyhooed and beloved Silicon Valley Bank. Then it was Signature Bank out of New York. If these weren’t enough, First Republic Bank has needed significant intervention from other larger market players. And across the pond, Credit Suisse, a $500+ billion banking behemoth, is being acquired by UBS Group in a Swiss state-backed takeover because of its financial woes. Whew, what a mess. Can’t we find a big thumb to plug the proverbial hole in the wall?
“Another Brick in the Wall” — Pink Floyd, 1979
Let’s just go ahead and address the elephant in the room—are we reliving 2008 and why aren’t regulators doing more regulating? Quite honestly, it gets bothersome bailing out bankers all the time, let alone very expensive. That’s right, ultimately you and I pay the bill for these kind of actions. I digress, so let’s move onto the question at hand and start by answering the last part first. There is a tongue-in-cheek expression that has been bantered around for years: “no one likes the Congress, but everyone likes their congressman.” Likewise, I would contend that no one likes bank bailouts, unless it happens to be their bank getting the bailout—there is more than a grain of truth to that. But what about the regulators, isn’t this where experience should be invaluable? Over my career, I’ve had to deal with regulators from various agencies and bureaus, and in aggregate, they all tell you basically the same thing: “we are not here to tell you how to run your business. We are here to make sure you are doing what you said you were going to do and that you are following the rules.” Without question, the government should not regulate away poor business decisions, let alone the impact higher interest rates have on asset prices. But, what about the first part of the question… are we revisiting 2008 again? While no one can look into the future with perfect clarity, I would suggest we are far from that happening. But exactly how far, you ask? Is it the next city block over or all the way across town? Is it the next county over or maybe as far as a neighboring state? Fair enough—I would propose we are from Tampa to Chicago and making the trip on foot.
“The reason for optimism is due to overall bank liquidity and capital.”
At the risk of sounding cavalier, I would posit the current problem with bank capital is more of an accounting function than widespread fundamental weakness. In fact, the powers that be (The Fed) could wave a magic wand and create literally hundreds of billions in new capital. Seriously, they could. If you harken back to Accounting 101, on one side of the ledger are assets; for a bank, these are largely loans, physical property, and bonds. On the other side of the ledger sheet are liabilities (in case you weren’t aware, deposits are liabilities for a bank). And as you probably know, the difference between assets and liabilities is capital. So, when the market value of a bank’s bond portfolio goes down, so does bank capital. While this is a very simplistic explanation, it really is just arithmetic. You see, banks can hold their bonds (and other assets) in one of two different baskets: One basket is called “Hold to Maturity,” or HTM, and just as the name implies, the bank holds these assets until they mature. To offset their lack of liquidity, the bank is allowed to account for these holdings on an “amortized cost” basis instead of their true market value. The other basket is known as “Available for Sale,” or AFS, and the securities held in this basket are used for general liquidity or to make money by trading. In essence, they are tradable assets, and the institution must report a true market value on each for accounting purposes. Hence the phrase “marked to market.”
If we presume there isn’t a catastrophic run on deposits around the country, government officials could permit banks to move their government bonds from their Available for Sale basket to the Hold to Maturity basket and assign higher amortized prices. This simple change in accounting would result in potentially much higher bond valuations for banks around the country. As a result, these elevated valuations would lead to more capital, and would make for stronger balance sheets. Remember, by definition, capital increases when assets go up and liabilities stay the same. But they can’t just do that, can they? I mean, changing the rules in the middle of the game—that’s just dishonest, and wouldn’t be appropriate. After all, banks are allowed to choose which bucket they use for securities, and as such, should consequently have to suffer or benefit, one way or the other. Furthermore, non-banking companies don’t get to reprice the asset side of their balance sheet out of thin air, so why should banks be allowed that privilege?
Well, two things I’ll say about that: first, I can’t argue with the last paragraph; it does seem a bit shady, and secondly, the Fed can pretty much do what it wants in this regard. Haven’t we seen them twist the rules enough over the years? Bail out a collapsing auto industry? Throw bankruptcy laws out the window? Engineer dodgy bank mergers? Create money out of thin air? And most recently, disregard long-established financial terms and metrics? If you responded with anything other than yes, I would submit you should rethink your answer.
“Unlike last time, banks will ultimately ‘get back’ their capital over time. It isn’t lost forever as it was back in the financial crisis of 2008.”
Let’s take a minute and compare the current mayhem to the 2008 financial crisis. What was the problem back then? Was it simply how banks accounted for their securities portfolio or was it because borrowers didn’t pay back their loans, en masse? Perhaps it was the fact that secondary markets for mortgages collapsed or that corporate credit spreads soared as demand for debt dried up and liquidity in the financial system essentially vanished? As I write, none of these things are currently present in our system, but that isn’t to say they never could or won’t happen. Well, since I sprung that leak… will it happen? There are only three sure things in life: death, taxes, and a 50% off sale at a jewelry store in the local shopping mall, so I rarely use the word “never.” However, I can confidently say that a 2008 financial crisis scenario is highly unlikely. The banking system collectively is much healthier than it was leading up to the collapse in 2008. Truthfully, it isn’t even close. The nation’s money center banks (JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo) are teeming with cash. At the end of 2022, these four banks represented roughly 60% of the assets and liabilities of commercial banks in the U.S., according to the Federal Reserve. Truth be told, they are too big to fail, no matter if we like it or not. In fact, the top 10 banking institutions in the U.S. make up over 80% of the banking assets in our country. According to Bloomberg, the Big Four had total loans and leases of nearly $4 trillion at the end of 2022. While that is a lot of money, they had more than $7 trillion in overall deposits with which to finance them. This alone suggests there was, and still remains, a ton of cash sloshing about in the banking system. Conversely, the FDIC had a balance of just $128 billion at the end of 2022 to insure deposits. After all the number crunching and numerical gymnastics, the cash and assets at the Big Four banks were equal to 19 times the size of the FDIC’s fund. Let that sink in for a second. If that doesn’t show us something about overall liquidity in the system, nothing will.
Though loan losses will likely increase over the next few years thanks to higher interest rates, the banking system is not overextended the way it was back in 2008. Again, this doesn’t imply numerous banks won’t feel the pinch due to higher interest rates—some have, some are, and some will. And finally, as I have already asserted, the bureaucrats can choose to create new capital by simply allowing banks to shift assets from AFS to HTM and reprice them accordingly without penalty. A thumb in the dike, if you will.
“With the benefit of hindsight, a review of their balance sheets would suggest these firms didn’t manage their liquidity very well. Unfortunately, they probably aren’t the only ones.”
All that being said, I am not too concerned about the near-term solvency of the overall U.S. banking system. First, interest rates would have to significantly increase from their current levels, and secondly, the Feds have a lot of tools at their disposal with which to mitigate the downside. As mentioned previously, some banks are rightfully anxious about their overnight liquidity and have been stretched due to higher interest rates and the decline in their asset values. Both of these issues have limited their ability to extend credit. However, aside from a few outliers, notably Silicon Valley Bank and Signature, I assert most of these banks are likely smaller in size. By smaller, I mean community banks with which most people are not familiar—The 2nd State Bank of Hooterville, that sort of thing. As a result, I suspect loan growth in rural America may come to a halt, if it hasn’t already. All of this will eventually lead to consolidation and fewer banks in the country. On the flip side, the recent failures should be a powerful lesson to bank leadership, most especially CFOs.
As you know, fear always sells and makes for great headlines. Likewise, fear can lead to bad decision-making or can be a very powerful motivator. It can make for sleepless nights, extremely long work weeks, and the hope that things will eventually settle down. Someday soon all of this staggering from one problem to the next will mercifully be over. In the end, if I have done nothing else this month, I hope to have eased some fears as they relate to our banking system and removed at least one brick from your wall of worry.
Until next month –
Be sure to listen to First Forward Podcasts for more financial insights.