Evening Brief – 05.03.23
The business of a bank requires borrowing short-term deposits and loaning long-term. That business model becomes more difficult when the yield curve is inverted, and short-term rates are higher than long-term rates. Inflation, tightening monetary policy and recession risks have caused the yield curve to invert to an extreme degree and it is making the business of banking harder – especially when rates have risen so rapidly in such a short period of time.
Giving banks time to adjust is the primary justification for raising rates incrementally instead of all at once, and the rapid pace of hikes and the Federal Reserve’s decision to raise rates again, and again, in the wake of Silicon Valley Bank’s collapse strongly indicates there is more trouble ahead, not behind, for regional banks and probably the sector as a whole.
The biggest change within the overall banking system has been to depositor dynamics. Usually, rising rates should help banks as yields on assets rise faster than the interest paid on deposits. But that relies on depositors being mostly stable users who don’t move their assets rapidly to chase yield or flee if the bank looks to be in trouble. Rich depositors with uninsured accounts were sleeping giants, and those giants have awoken, to the detriment of Silicon Valley Bank and First Republic, and other banks that depend on them.
While the weekend resolution of First Republic was supposed to ease investor concerns about a banking crisis, regional bank shares immediately tanked on Tuesday, and saw only a mild recovery on Wednesday, amid speculation that others will need to be saved.
One would expect higher rates to improve bank profits. But things are different now. Along with the inverted yield curve, the Fed has helped make money-market rates attractive enough to attract depositors. There is also the issue of the bank regulations enacted following the 2008 Great Financial Crisis, which compelled banks to increase their US Treasury holdings and are mostly now underwater. All this reinforces a growing view that the Fed will stop raising rates sooner than they’ve been leading us to believe.