Around the second week of March of this year, Silicon Valley Bank and Signature Bank, both American banks, went bankrupt due to the massive withdrawal of deposits that forced them to sell assets to be able to face the withdrawals and to recognize losses for said sales that consumed the capital of these. But what led them to this situation? In part, it can be explained by poor balance sheet risk management in these entities. However, it can also be attributed to the macroeconomic measures implemented in the COVID era by the American government.
On the monetary side, there were important reductions in interest rates and a significant increase in the money supply. On the fiscal side, fiscal spending was increased and money was sent directly to the pockets of American families. Faced with this enormous amount of money injected into the economy, American banks went from having $13.2 trillion (million million) dollars in deposits at the end of 2019 to having $18.2 trillion at the end of 2021 according to data from the FDIC, (Federal Insurance Corporation of Deposits). But given the slowdown in economic activity as a result of the pandemic, banks were unable to put all this money into loans. As a consequence, the loan-to-deposit ratio of commercial banks in the United States fell from 72.4% to 57.1% in the same period. The surplus money was invested in financial instruments, such as US Treasury bonds and mortgage-backed bonds, when interest rates were at record lows. The speed of rate increases in the United States did have a significant effect on these investments. A gradual increase in interest rates allows banks to gradually absorb losses due to depreciation of their investment portfolio against the profits generated by the traditional financial intermediation business. However, when the increase is accelerated, as happened in 2022 with the Federal Reserve (FED) increasing its rate by 425 base points, the losses due to depreciation accumulate significant amounts and have a substantial impact on the profitability of the banks, forcing them to to implement accounting practices to avoid recognizing these losses in their income statements.
The more lax banking regulation implemented by the Donald Trump government allowed banks with assets of less than $250 billion dollars not to include these losses in their capital requirements because they are not considered systemically important banks and are not part of the stress assessment , arguing that these measures would decrease the operating cost of these banks, making them more competitive. Clearly, the lesser regulation of regional banks did not allow for the timely identification of interest rate and liquidity risks that ended up causing a banking crisis, a fact that has been strongly questioned by both the Senate and the United States House of Representatives.
It is clear that, from now on, there will be greater supervision of regional and local banks with more demanding liquidity and capital requirements, which will negatively affect the profitability of these banks. One way to offset lower profitability is by increasing the size of banks. Today there are about 4,706 banks or savings institutions in the United States, one for every 71,000 residents. In Europe there is one bank for every 85,000 people. At the end of 2022, more than 400 banks with combined assets of almost $4 trillion dollars have unrecognized losses in their investment portfolios equivalent to half of their Tier 1 capital, so the risk of further bankruptcies persists. Taking advantage of the lower valuations of these banks, a stage of bank consolidation, mergers and acquisitions between banks will begin, which will reduce the existing number of them.
A second consequence that is observed is the withdrawal of deposits from American banks for a value of $563.2 billion dollars so far in 2023 (as of April 12), which shows signs of stabilization. The 25 largest banks had a 2.3% or $251.5 billion decrease in their deposits while the rest of the banks have seen a 4.5% or $311.6 billion decrease in their deposits so far this year. A large part of these deposits have migrated to monetary investment funds that offer an average return of 430 bps more than the average rate paid by deposits in American banks. In order to retain deposits, banks have begun to raise their deposit rates for both their savings accounts and term accounts, which leads to an increase in the cost of funding and lower profitability, mainly for small and medium-sized banks.
And a third consequence is credit crunch. In the reports to the first quarter of 2023, the systemically important banks reported that they have not materially adjusted their credit standards, however, the regional banks reported that they have already reduced their loans or that they will do so soon due to the increase in the cost of funding and capital requirement they face. The International Monetary Fund estimates that the impact of the loan contraction on growth for the United States is 0.44% lower growth for this year. This plays in favor of the Fed, which has been raising its monetary policy rate to try to cool the economy and controls inflation. The effect of this credit restriction is equivalent to 1 or 2 increases of 25 basis points in the Fed’s monetary policy rate. For this reason, the market is only waiting for an additional 25bps rise at its meeting on May 3 and for the Fed’s monetary tightening cycle to end there.
Although the perception of risk caused by the banking crisis experienced in March has been diluted, scars remain that, in short, will change the outlook for the remainder of 2023.
*The author is Executive Director, BBVA Fixed Income Latam
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