Bank Balance Sheet Mishaps, Liquidity, and What Comes Next

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The banking industry’s ongoing liquidity crunch took an unsettling turn in early March as the FDIC closed three large regional banks, each with its own unique set of circumstances. While the industry’s widespread bond losses and liquidity strains did set the stage, it was ultimately fast growth, a unique funding model, and untimely management decisions that culminated in the bank-level collapse. The good news is that the individual themes are not common among the banking industry, but these closings still sent shockwaves through markets and boardrooms.

The new Federal Reserve lending facility (BTFP) and the announcement that all depositors of the failed banks – uninsured included – will have immediate access to all their funds added some needed clarity to the state of affairs, though the situation remains fluid. While the contagion around this episode has been contained, the early days of March 2023 will likely have lasting ramifications on bank balance sheet management and regulatory scrutiny, and perhaps a more immediate impact on Fed policy. Balance sheets and interest rates are intrinsically linked, and the outlook for both drive decisions around asset/liability management, liquidity planning, and ultimately profitability.

Liquidity Stable but Margin Concerns to Follow

Regional and community banks are acutely aware of liquidity needs. While a bank run crisis has been averted, attention is shifting to rising funding costs and impact on net interest margins, which directly correlate to the Federal Reserve’s tightening path. The eventual pivot, while still likely further away than the market expects, may not provide the funding cost relief many bankers have become accustomed to over the past decade of 0% interest rate policy (ZIRP).

While there remains a disconnect between various market signals on the direction of economy, the Fed Funds futures market sits squarely in the pivot camp. This outlook is debatable, but we should pay attention to what it may mean for future funding costs and earnings growth.

Current Fed Funds futures incorporate 100-200bps in rate cuts to reach an approximate 3.75% Fed Funds rate by the end of 2024. Assuming a neutral Fed Funds rate of 3.75% is not recessionary pricing and is much different than the last 15 years. Now considering the historical average spread between Fed Funds and the cost of interest-bearing deposits is near 100bps, this would imply an average cost of funds of 200-250bps over time, a far cry from what many banks have become accustomed.

Taking this exercise a step further, consider that today’s average investment portfolio yields are just under ~2.50%. Bond portfolios account for 15-25% of banks’ total asset base and are turning over at a much slower rate. This is a recipe for significant margin compression in 2023 and well beyond.

Hard Landing for Loan Growth?

Loan growth boomed throughout 2022, but as we enter the second quarter of 2023, cracks are starting to emerge. The most recent loan officer survey data points to a bleak outlook for growth and a potential for worsening credit conditions. While call report data continues to show strong growth, sentiment has shifted. Bankers’ expectations for lending demand among most loan segments are falling rapidly and lending standards are tightening across the board.

The “good” news is that slowing loan growth frees liquidity, however from a credit perspective, banks are pulling back and tightening lending standards. While credit conditions remain pristine, we are seeing an increase in provisions and expect at least a return to more normal levels of credit quality. A resulting effect of tighter liquidity and lending conditions could pose recession risk for the overall economy.

Unrealized Bond Losses and Balance Sheet Management

It comes as no surprise that bank portfolio management has been challenging over the past 18 months. Interest rate volatility, unrealized losses, and limited liquidity has constrained many managers and stressed balance sheets. Unrealized losses in bank bond portfolios continue to lead many discussions in management meetings and board rooms. At the end of the 4th quarter, bank bond portfolio unrealized losses, inclusive of HTM, stood at 10.2%. This is by far the largest unrealized loss in recent memory and over a 3+ standard deviation event given the past 20-year history.

Large unrealized losses in investment portfolios create three main concerns, some more acute than others.

The current priority is liquidity. Amidst 2022’s booming loan growth and flat-lining deposits, the significant move in interest rates – and accompanying unrealized losses and duration extension – simultaneously limited the portfolio from providing its usual liquidity ballast. While a small subset, institutions with negative tangible equity due to unrealized bond losses also face limited wholesale funding options, putting further strain on liquidity and margins.

While a secondary consideration today, earnings growth will continue to drive equity valuations. Asset yield levels are the most attractive we have seen in quite some time, but the capacity to reprice the balance sheet is ultimately constrained to current liquidity and wholesale funding options. Current loan growth has offset this issue in earnings for the time being, but as that growth slows and funding costs rise, the need to reprice the investment portfolio becomes paramount.

Lastly, capital considerations are vital. While not affecting regulatory capital, unrealized losses do impact GAAP capital and tangible equity, lowering Tangible Common Equity/Tangible Asset ratios below the comfort zone of most boards. There has been a downward shift in TCE/TA ratios for regional and community banks in the last three quarters. At the end of 2021, only 3% of banks were below 7% tangible common equity. Today that number of banks is near 30%.

What’s Next?

Financial institutions are currently focused squarely on deposits and liquidity. While these concerns are pressing, bank valuations remain fundamentally driven by future earnings potential. Some liquidity pressure may be relieved throughout the year as loan growth wains, but this may also result in quicker margin compression. Going forward, bankers should be keenly aware of the potential for changing credit and lending conditions. While recent events have made proactively repricing balance sheets more nuanced, future margins will be built in today’s yield environment. Banks should prioritize liquidity, manage credit, and build earnings power for the future because equity investors continue to prioritize future earnings growth.