Market Commentary: May 2023

With three bank collapses in the past two months, investors are wondering what it means for the banking sector in general. We sat down with Gabe Lembeck, MBA, CFA, Director, Investment Strategy Team, to get his perspective.  

Investors feel anxious about recent bank failures, especially because it feels reminiscent of the Great Financial Crisis. What are your thoughts?  

While we do believe there is going to be further stress to manage over the coming quarters, we do not believe this is parallel to the financial strain experienced in 2008. It is easy to forget, given it has been about 15 years, but 2008 — as well as many other historical banking episodes — were less about liquidity and more about solvency.  

Could you describe the difference between these crises?  

In 2008, tremendous credit losses from mortgages and derivatives linked to those mortgages depleted bank capital. In addition, the bonds banks did own were inherently worthless as mortgages were increasingly falling into forbearance and then default. This rendered much of the banking system insolvent – unable to pay its debts.  

Earlier this year, Silicon Valley Bank (SVB) experienced a liquidity problem as investors clamored for their deposits. This forced the bank to sell bonds prematurely. Unfortunately, the bonds owned by SVB were not worth as much as the price paid for them because of the rise in interest rates over the preceding months — recall that bond prices fall as interest rates rise — so SVB suffered huge losses.  

In other words, without the immediate need for cash to pay the mammoth amount of demanded deposits, SVB could have held those bonds to maturity and had the necessary cash flow to pay the standard daily deposit demands. Again, this is a crucial distinction with 2008, when banks' assets were inherently worthless.

SVB experienced a classic bank run – and I want to note that the banking sector as a whole cannot experience a bank run because the assets withdrawn from one bank are typically transferred to another bank in the system. However, individual banks certainly can experience them, and SVB was set up for a classic bank run not only because of the concerns over their assets, but also because they had a far higher percentage of uninsured deposits (i.e., accounts with balances over prescribed FDIC insurance limits) than other banks, owing to a concentration of clientele composed of two major groups: 1) cash-burning companies in the venture capital space, and 2) high net worth individuals who carried large balances.

You mentioned that the banking sector cannot experience a run. Can you elaborate?  

Any funds removed from one bank will eventually end up in another bank. Though depositors could leave the U.S. banking system for an entirely different system, such as one in another country, it is not practical for most depositors.  

For example, in the wake of the withdrawals at SVB, deposits swelled at the four biggest banks — Chase, Bank of America, Citigroup, and Wells Fargo — and deposits remained level in the system as a whole.  

This is also true for other financial instruments. If someone takes their cash and buys U.S. Treasuries in the secondary market, whoever sells the Treasuries eventually deposits the money into a bank account. Purchasing U.S. Treasuries directly from the government issuance does remove money temporarily, but then that money is deposited back into the banking system as soon as the government spends the money. The same holds true with purchases of money market funds. No matter how we look at it, it is a zero-sum game among the individual banks in the system, but it is not a depletion from the system itself.

Is there anything that does take deposits out of the system?  

The only thing that truly can remove deposits from the system is central bank quantitative tightening, which serves to reverse all the excess deposits that were created from quantitative easing.  

We’ve recently seen this play out in the market. Since peaking last April, bank deposits have fallen consistently as the Fed has been sopping up liquidity via quantitative tightening.  

While a bank run is bottom-up, driven by individual depositors, quantitative easing and tightening are top-down, driven by the Federal Reserve. Quantitative tightening reflects a conscious decision by the monetary authority to reduce the amount of money in the system, which is something they can stop and reverse at any time they want, likely when they are comfortable with the inflation level.

Can banks do anything to protect themselves from bank runs?  

Banks can limit the number of deposit withdrawals by raising the rates they pay depositors. Simply, with higher rates, depositors are more likely to keep their money in the bank to increase interest earnings.  

In fact, many smaller banks have raised rates to stem deposit outflows to larger banks. These rates have been lower than the Federal Funds rate but, in many cases, are now in line with or even above the Federal Funds rate, a move which is likely to hinder profit margins but will lead to individual banks maintaining liquidity.

Credit Suisse failed a few weeks after SVB and First Republic failed last week. Did they also experience bank runs? The failure of multiple banks feels like the start of a bigger trend.  

Credit Suisse (CS) was a solvency issue, as they have been struggling for years with concerns about their derivatives book and other assets on their balance sheet. CS was an idiosyncratic European issue, as we see other European investment and money center banks have experienced nothing other than a relatively modest decline in their stock prices. The failure of CS should not be grouped with what is occurring in the U.S. regional banking system.

U.S. regional banks are feeling pressure as investors target them more so than they target larger banks owing to a greater cost of capital and a likely less sticky client base, which makes those banks more subject to bank runs than the larger banks.  First Republic (FRC) failed after experiencing a bank run similar to that of SVB. FRC’s deposit base was composed similarly to SVB, though it was somewhat less extreme in its client concentration, and the carrying value of its assets was low due to rising interest rates during 2022.

This pressure will continue. The two most notable concerns now are Pacific Western Bank (i.e., PacWest - PACW) and Western Alliance Bank (WAL) — and it likely will not stop with those two as interest rates continue to rise and investors continue to comb through their balance sheets seeking out those banks with balance sheets composed similarly to those that already failed.

But the good news is that at some point, it will end. Reiterating our earlier statement, the banking system as a whole cannot have a bank run, but it is indeed possible that deposits could flow from regional banks upstream to the bigger money center banks, for example, J.P. Morgan Chase (JPM) and Wells Fargo (WFC). This is what we saw early on as depositors withdrew their funds from SVB and placed them in larger banks as well as when JPM purchased FRC.  

So, this crisis is more of a concern for regional banks than the banking system as a whole?  

The concern here is not that the entire banking system will collapse, as we mentioned earlier, but rather that the concentration in banking will grow (i.e., the big banks will get bigger) leading to further longer-term risks; while such action may stem the bleeding for now, it could beget other problems down the road.  Additionally, a lessening regional bank presence is likely to have a substantive longer-term effect on the economy given much of small business America receives its debt capital and working capital credit lines from local regional banks. Any impact on the regional banking system to the benefit of larger banks, while it may not bankrupt the system as a whole, may weaken the ability over the longer term for small business America to grow.

Any closing thoughts?  

Individual regional bank shareholders may have concerns about bank stability, but the banking system as a whole is not in danger of collapsing. This differs from 2008, in which systemic capital was lacking on the back of impaired mortgage assets.  

But again, there could be concerns about a shrinking of the regional bank sector which may impact U.S. small businesses over the long run.  

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For more information about the banking crisis, you can read:  

Top of Mind: This monthly feature which provides our take on the latest news in the financial sector. In April, we answered: "What happened with SVB?" "Is my money safe?" and more.

The Federal Reserve’s Trilemma: CEO Adrian Cronje, Ph.D., CFA reflects on SVB’s failure, the ensuing trilemma for the Federal Reserve in the face of an increased risk of recession, and how Balentine is protecting client assets.

Four Things to Remember in a Banking Crisis: We provide considerations for how your wealth is managed and invested amidst market dislocations.

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