Judging by the recent absence of scary headlines, one might conclude that the banking crisis touched off by Silicon Valley Bank’s March 10, 2023, failure is over. There have been no major failures since Signature Bank’s on March 12 and First Republic’s on May 1. By May, deposits at U.S. banks were on the rise, indicating that pressure from withdrawals by anxious depositors had eased.
Despite the May increase from $17.18 trillion to $17.19 trillion, however, deposits remained below March’s $17.37 trillion, according to the Federal Reserve. The chart below similarly tells an off-the-bottom-but-still-down story.
Source: Bloomberg Professional Services and Internal Calculations
The SPDR S&P Regional Banking ETF (KRE) tracks the small-, medium-, and large-cap regional bank stocks within the S&P Total Market Index on an equally weighted basis. As the graph shows, shares of regional banks dropped off sharply relative to the all-industry S&P 500 when the crisis began in March. Regional banks continued their relative decline in April and early May. Since then, the stocks have regained a bit of ground, but they are still worth only about 65% as much as they were, in relative terms, at the beginning of 2023. The market, in short, does not believe that the sources of this year’s banking sector shocks have been eliminated.
Ongoing Concerns
Investors’ skepticism about restored health in the banking system is justified on several grounds.
Source: Bloomberg Professional Services and Internal Calculations
Interest Rates - to begin with, a precipitating factor in the three abovementioned failures was the sharp rise in interest rates, which the Federal Reserve instigated to combat the inflation surge that began in 2021 and peaked in 2022. Rates have by no means returned to their pre-2021 levels. For example, the three-month Treasury bill yield is higher than at any time point in the previous 20 years.
Yield Curve Inversion - particularly problematic for banks is the continuing yield curve inversion. In their role as financial intermediaries, they earn a profit by paying short-term interest rates on deposits and lending the funds at the ordinarily higher rates paid by longer-term borrowers. That arithmetic does not work with the ten-year Treasury rate 135 basis points below the three-month T-Bill rate, as was the case on July 21. (One basis point = 1/100 of a percentage point.)
Bond Portfolio - as the financial press frequently mentions, bond prices fall when yields rise. Regional banks’ holdings of bonds—including default-risk-free U.S. Treasury obligations—have lost value due to the sharp rise in interest rates. The banks consequently have sizable unrealized losses on their investments.
Unrealized Losses on Available for Sale Securities - for most of the banks represented in the SPDR S&P Regional Banking ETF, the unrealized losses represent less than 3% of total capital. That sounds small, but in 2022, average capital as a percentage of total capital for U.S. banks was just 8.6%, according to the World Bank. This means that with unrealized losses as high as 7% of total assets at a few banks, a sudden necessity to realize those losses for liquidity reasons could take a deep bite into their capital.
FDIC Insured Deposits - a further concern is that at some banks more than 50% of deposits are uninsured because they exceed the $250,000 Federal Deposit Insurance Corporation (FDIC) cap. Fear of possible losses on the part of uninsured regulators helped trigger the bank run at Silicon Valley Bank that launched the banking crisis. It is true that regulatory resolutions of 1H 2023’s three large failures prevented even uninsured depositors from suffering losses. There is no guarantee, however, that uninsured depositors in a future bank failure would receive similar treatment. At some point, the regulators might choose to make an example of one bank, much as happened to Lehman Brothers during the 2008 Global Financial Crisis, after other financial institutions were bailed out by the government.
Commercial Real Estate Loans - one final reason to be highly selective about the regional banks is the high concentration of many of their loan portfolios in commercial real estate (CRE) loans. Real estate operators that borrowed at exceptionally low prevailing rates a few years ago will find it difficult if not impossible to refinance their loans at rates they can afford. Those cash flow problems are exacerbated by vacancies resulting from the pandemic-induced acceleration toward work-from-home. In addition, consumers’ shift to online shopping has made a great deal of retail space redundant. Regional banks with large CRE exposures face the prospect of sharp increases in their loan charge offs, further depleting their capital.
Interpreting Credit Ratings
Investors might take some comfort from the investment grade ratings (Baa3 or higher by Moody’s, BBB- or higher by Standard & Poor’s) at most banks. ICE Indices’ index of below-investment-grade banks currently contains just three U.S.-based institution— Pacific Western Bank. Texas Capital Bancshares, and Western Alliance Bancorporation. Of the 11 large-cap regional banks in the S&P 500, however, three have negative rating outlooks from Moody’s, Standard & Poor’s, or both.
Minor downgrades at those three banks would not drop them below investment grade, but that is cold comfort for investors. All three failures discussed above occurred at banks that enjoyed investment grade ratings until shortly before they failed. Unlike bankruptcies at industrial companies, which generally take place gradually, following multiple credit downgrades, bank failures can occur abruptly in response to an overnight loss of confidence by depositors. For a bank, therefore, a rating in the A to BBB range does not constitute as reliable a sign that default within 12 months constitutes a negligible risk as it does for an industrial company.
Investment Conclusions
For multiple reasons, it would be premature to send out an “all clear” signal on the banks. Accordingly, we are maintaining a highly selective approach to owning preferred and common stocks in this sector.
We are confident in the soundness of the Systemically Important money center banks, informally deemed “too big to fail.” Their exposures are well diversified, both geographically and by industry sector. The U.S. banks in this regulatory category are:
Bank of America
Bank of New York Mellon
Citigroup
Goldman Sachs
JP Morgan Chase
Morgan Stanley
State Street
Wells Fargo
Among the regional banks, we are committing capital only to those that pass a stringent test of financial soundness. To determine whether a regional meets our standards, we monitor both its financial data and relevant market signals. Among the financial measures we track are percentage of deposits that are FDIC-insured, unrealized losses on securities, and trailing-12-month net charge-offs. Market signals included stock price return (daily and year-to-date) and short interest as a percentage of float (the number of shares publicly traded).
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