(Bloomberg) - After the most tumultuous month since the 2008 financial crisis, banks are finding themselves in an impossible position.
Keeping interest rates on deposits near zero is becoming increasingly untenable, with the collapse of Silicon Valley Bank, Signature Bank and Silvergate Capital Corp. putting savers on high alert for better and safer alternatives. But raising rates enough to compete with money-market funds is also a nonstarter that would crush profit margins and potentially roil stock prices.
It's forcing a rethink about the traditional role lenders have had in the US financial system and the economy — and whether there are just too many of them.
The turmoil has underscored that there are other places people and companies can park their spare cash and get a better interest rate. Over the past three weeks, what had been a slow flight from low-yielding savings accounts has become a turbocharged sprint to higher-earning alternatives. And smaller banks are feeling the pain much more acutely than their giant peers. Deposits at such lenders slumped $120 billion in the week ended March 15, while those for the 25 largest firms rose almost $67 billion, Federal Reserve data showed.
For more than a decade, banks had been able to pay rock-bottom rates to depositors. When the Fed slashed interest rates in the financial crisis, it opened a low-rates era that allowed banks to borrow cheaply and earn handsome profits from lending.
Now, the ground is shifting. The Fed has been raising its borrowing benchmark at a rapid clip over the past year in a bid to tamp down inflation — but banks have been slow to boost the rates they offer to customers, fearing what it will mean for their margins.
“The bottom line is, deposits were really taken for granted for a very, very long time because of the zero interest rate environment, and now that’s completely changed,” said Joseph Plevelich, senior research analyst at Pekin Hardy Strauss Wealth Management.
Even before the rapid-fire bank collapses, lenders had been confronting strains created by the Fed's aggressive rate hikes. Lower-yielding investments and loans are dragging down bank profitability even as it becomes more expensive to borrow money to fund further lending.
Money-market funds, on the other hand, have been much more nimble in passing on the Fed’s rate hikes. There is now a record $5.2 trillion piled up in them and some predict that the flow from banks to funds can go even further.
Money funds park cash in short-term instruments, such as Treasury bills or repurchase agreements, and pass on what they earn to investors. Though the immediate anxiety about more bank failures has eased, investors have continued to pump cash into money funds, pushing some $66 billion into US money funds in the week ending March 29, according to the Investment Company Institute.
Less Lending
The move from bank accounts to money funds and other instruments is likely to put more cash in the pockets of long-suffering savers, but there is concern that a dearth of deposits will leave the US with a smaller number of community and regional banks who have less money to lend — and that in turn could hold back growth and worsen inequality.
Many banks are barely trying to compete with money-market funds to lure customers back. They're either unwilling or unable to raise deposit rates as they're still suffering from losses from investments made in lower-yielding assets before the Fed began raising rates. Some banks that dangled higher rates have collapsed: Signature and SVB offered among the highest deposit rates in the industry.Read more: Why US Banks Are Hemorrhaging Deposits to Money Funds
Even the nation's smallest banks play a major role in the economy. A 2020 Federal Deposit Insurance Corp. report indicated community banks — institutions with $10 billion or less in assets — held 36% of small business loans, even though they accounted for only 15% of total loans within the sector.
Bank loans are a crucial source of funding for small businesses, which employ about 46% of Americans who work in the private sector and have generated nearly two-thirds of jobs created since 1995, according to the US Small Business Administration.
The prospect of widening wealth inequality — a trend that the Fed was hellbent on reversing as part of its 2020 framework change — looms large for economists including Krishnamurthy Subramanian, an executive director at the International Monetary Fund.
Community and regional banks are crucial lenders to individuals and small businesses far removed from the biggest, wealthiest US cities.
“The people who bank with them, who are not as well-to-do,” will be most affected by the struggles of smaller banks, said Subramanian, a former chief economic adviser to India's government. “Large banks will not be the ones hit this time.”
Plugging the Gap
For now, the fallout from the deposit exodus has been contained. The Fed, along with the Federal Home Loan Banks, has plugged a big chunk of the funding gap. And the FDIC’s decision to backstop previously uninsured deposits at SVB and Signature Bank has helped ease some savers’ concerns about the safety of banks.
However, some industry observers say those steps can only buy so much time, and that the flow of funds away from lenders will likely go on.
“Until the regulators or the government say in fact all deposits are insured, the implied insurance doesn’t really count,” said Joseph Mevorah, a senior managing director with Empire Valuation Consultants. “Over the course of the next few months, you’re going to see a steady trickle away from those banks.”
Mevorah started his career liquidating failed or failing thrifts during the savings and loan crisis, financial panic sparked by aggressive interest rate hikes that led to a federal bailout for the industry and an overhaul of banking regulation.
A steady drawdown of deposits isn’t the only challenge facing banks.
Since the Fed’s fight against inflation began, banks have watched the value of their substantial bond holdings erode, as debt bought when rates were lower is worth less as rates climb. The same can be said of mortgages and other loans banks made when customers who were eager to lock-in low rates opted to borrow.
While accounting quirks have shielded banks from the worst impacts of those unrealized losses, banks are still facing significant friction that will erode profits in the short term and could do more damage down the road.
Margin Squeeze
It was clear even before the most recent crisis that some banks were leaking deposits, pushing them to lean more heavily on alternative funding sources, such as the FHLB system.
Some also responded by boosting the rates they offered on deposits in a bid to lure back savers, but even with that average rates remained well below what money funds and other venues were able to offer.
Jacking up interest rates on savings accounts and certificates of deposits can draw in cash, but it's also likely to squeeze banks’ net interest margin, or NIM, a key measure of their financial health that compares how much they make from interest-bearing assets like loans against what they pay on interest-bearing liabilities like deposits.
“That earnings number will look way worse,” said S&P Global analyst Nathan Stovall. He said that could lead to consolidation if it pushes bank executives who were already contemplating a sale past the tipping point.
“You might’ve been willing to accept some margin compression. You might’ve been willing to accept a 5% decline in earnings,” said Stovall. “But are you willing to accept 10 or 15? I think that could push people over the edge.”
By Max Reyes, Alex Harris and Benjamin Purvis
With assistance from Brian Chappatta, Dan Wilchins and Blake Schmidt
