Andrew Pyle
March 20, 2023
Liquidity risk exists for banks, but for business and households too
This has been quite a week for investors. Following on my last commentary, a major tech sector bank saw its collapse become worse over the week, enveloping another crypto-centric bank and then another California medium-sized bank. Losses in most major banking sub-groups extended into Monday and throughout the week until Thursday, aided along by widening stress fractures at Credit Suisse – aptly nicknamed “Debit Suisse” after it took a 50 billion euro loan from the Swiss National Bank (SNB) on Thursday morning (right before my interview on BNN Bloomberg – click here to view the segment).This weekend, the Credit Suisse story took a major turn after it was announced that UBS would be acquiring the bank for 3 billion swiss francs – less than half of what that firm’s market cap was a week ago.
Over the course of this week, I have discussed with many of you about what is happening, what it means for our investments and how it may impact our financial plans. At the core, these questions can be boiled down to “just how systemic of a risk are we dealing with?”. Firstly, let me say that I don’t believe we are re-living a 2008 moment here. There are no certainties, of course, but the general health of the global banking sector today is stronger than where it was prior to the financial crisis. New regulations put in place after that experience have strengthened bank balance sheets and practices, by large.
Central banks, governments, deposit insurance agencies and regulators also learned a lot during the Global Financial Crises (GFC) and have been able to apply that knowledge to the current situation. The US Treasury and Federal Deposit Insurance Corporation jumped in to place an insurance blanket over all deposits to quell the panic exodus that was created with SVB. Note, the bank lost more than $40 billion in deposits in one day as social media lit up with concerns over the bank’s health. It took a week for the same drainage to occur with Washington Mutual during the GFC. It’s important to remember that there haven’t been any defacto government bailouts as yet. Depositors have been protected, and central banks have put measures in place to enhance liquidity. The Federal Reserve has provided lending for banks using 100% of the assets they put up as collateral (as opposed to a discounted value) and the Swiss National Bank provided roughly a $100 billion liquidity line to UBS as part of the Credit Suisse acquisition.
Then there is First Republic Bank headquartered in California. This isn’t a tech startup or crypto bank. In fact, its core strengths are private banking and wealth management. As the chart below shows, the stock has fallen more than 90% from its peak north of $200 in late 2021. Unlike the two tech-centric banks in disarray, First Republic didn’t have a high concentration of its deposits in one sector (tech) and it diversified its deposit base such that no more than about 9% was in any one sector. The growth in First Republic’s assets since 2019 was impressive at about 80%, but this was small in comparison to the other California bank’s growth of 200% (source: Bloomberg).
The issue for these two banks (and others) was deciding to place a chunk of deposits in US Treasury bonds in 2021. Now, it’s routine for banks to have low-risk government bonds on the balance sheet but, in the case of First Republic, that amount had grown to 15% by 2022. The other bank’s share was close to 60%. If we weren’t in the middle of the most aggressive central bank policy tightening agenda since the 1990s, this may not have been bad.
On top of that, depositors started to see a need to pull out. In the case of the Califorina tech bank, this was mainly because its primary sector was feeling a lot of pain in 2022 and companies (clients) were in need of liquidity now that the private equity and venture capital horses were bolting. In 2021, demand deposits at that bank were $126 billion. In 2022, they fell to $81 billion, however, interest-bearing deposits rose by almost $30 billion to $92 billionThe story was somewhat similar for First Republic. Total demand deposits did slip about $8 billion to $62 billion in 2022, but interest-bearing deposits also jumped about $30 billion to $114 billion. In both cases, to say nothing for most banks, depositors were simply looking for more interest and started to move out into things like certificates of deposits (CDs – think GICs).
The compounding problem for both banks was that the majority of deposits were uninsured. What this means is that if an individual or company places a million dollars with an FDIC member bank, only $250,000 is insured (here the CDIC insures up to $100,000). In the case of the Califorina tech bank, most deposits were extremely large, thus exceeding this cap. For First Republic, it’s wealth management clients were also high net worth and therefore a large segment of those assets were uninsured.
As we head into the weekend, the difference between the two banks is that the tech bank has now filed for Chapter 11 bankruptcy and no one really knows whether a buyer steps forward, or the assets simply get spun off. First Republic received $30 billion in committed financing from 11 of the largest US banks ($5 billion each from JPMorgan Chase, Bank of America, Wells Fargo and Citigroup and $2.5 billion from Goldman Sachs and Morgan Stanley). As I mentioned on BNN, I don’t see this as being the contagion event that took place in 2008. That doesn’t mean that additional smaller banks with issues pop up. For those banks that were mismanaged, it is perhaps a good thing that their deposits end up with another more viable bank. For those that simply got caught in the crossfire of high-frequency headlines, stability should return. In fact, we see this as an opportunity to pick up US banks at attractive valuations, as we have started to do this week.
Yet, there is also a lesson here for depositors themselves. As attractive as it has looked to rotate chequing and/or savings deposits into higher-yielding vehicles like CDs or GICs, liquidity is also important. Deposits can be accessed for day-to-day or emergency purposes. Most term vehicles cannot (and those that offer the flexibility of access will typically offer lower rates). If we see stability return to this sector in the near future, and underlying inflationary pressures remain, then it is likely that at least the Federal Reserve will push interest rates higher. The European Central Bank (ECB) has already stuck to its guidance by raising rates half a percent this week and that was right in the thick of the banking melay. Jerome Powell and the rest of the FOMC will decide on rates next Wednesday, with a lot more time to digest events. Higher rates will raise the probability of an economic setback, where businesses and households will need access to liquidity. As I commented, it’s not the banking sector that keeps me up, but the economic risks down the road. Rather than locking in, it’s better to stay liquid and nimble.
Andrew Pyle
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