Not Out of The Woods Quite Yet
TL;DR: The banking system seems to be stabilizing, at least for now, but we are concerned that liquidity problems will before long be supplanted by credit problems. In this report we offer thoughts on what to watch, and on energy finance as just one of many, as-yet little examined, potential long-term effects of this crisis.
Deutsche Bank isn’t Credit Suisse. Deutsche Bank renewed contagion fears on Friday, as CDS spreads widened sharply and the stock dropped by 10%. On one hand, there are some key differences, starting with the fact that Deutsche Bank is decently profitable, in aggregate as well as in each of its key components. The bank boasts a CET1 ratio of 13.4% and a Liquidity Coverage Ratio of 135%, although any solace to be found there is mitigated by the fact that Credit Suisse failed with a CET1 ratio of 14.15% and a Liquidity Coverage Ratio of 144% (which had risen to over 150% by March 15).
The derivatives book is large both in aggregate and, more importantly, in the Level 3 column. Deutsche also has material exposure to the US commercial real estate market, and that is certainly a market that bears close watching, but if that represented a clear threat to solvency at Deutsche then it would do so even more fully at many US banks, and the market doesn’t seem to be discounting such a thing, at least not yet. For the time being, the key things to watch (beyond CDS spreads) are whether counterparties begin limiting exposure, and whether global regulators begin actively tracking their banks’ exposures, which were among the few visible indicators of severe distress at Credit Suisse.
Whither First Republic? Two weeks after the failures of SVB Financial and Signature, First Republic remains in limbo, as yet unable to find a buyer or a path to survival, but seemingly with the support of regulators to continue trying. JP Morgan Chase bankers working to save the bank have reportedly been augmented by teams from Lazard and McKinsey; one hopes the bank didn’t survive a run only to be done in by a crushing burden of professional fees. A noteworthy contrast with the two failed banks are reports, admittedly anecdotal
yet accumulating over the past two weeks, of customers who recognize the severity of the situation yet refuse to move their accounts because they are so happy with the service they receive there. Whatever becomes of First Republic, it will live on as a case study in the decommoditization of a commodity business.
First Citizens BancShares assumes assets and liabilities of SVB Financial. The transaction will double First Citizens’ balance sheet to $220 billion in assets, not long after the CIT acquisition doubled the bank’s balance sheet to its current size. A conference call was scheduled for 8:30 this morning.
March 22 Federal Reserve balances suggest stabilization. Figure 1 highlights the key data points from last week’s release of Federal Reserve balances (Release H.4.1). The data suggests a measure of stability; after a surge in primary credit (the Fed Discount Window) in the week ended March 15–the first week of the crisis–use of the discount window declined by a similar amount to the increase in usage of the new Bank Term Funding Program in the week ended March 22. The combined total declined by just under $1 billion or 1%, to $164 billion. As of this writing, the borrowing rate under the BTFP is 4.38%, or 62bps less than the discount window, and under the BTFP collateral is valued at par regardless of market value, which presumably explains the mix shift. Other credit extensions–essentially loans to failed banks–rose 26%, or $37 billion, to $180 billion.
Figure 1: Federal Reserve Balances
Source: Federal Reserve
Decline in total commercial bank deposits accelerates. Figure 2 illustrates the decline in total bank deposits; while the overall downward trends has been in place for some time, the most recent data, for the week ended March 15, shows a significant acceleration, with total deposits down $98 billion, or 0.56%, in the first week of the crisis. The same release shows that, at least during the first week, the decline in deposits did not lead to a contraction in bank credit; total loans rose $63 billion, or 0.52%, for the week.
Figure 2: Total Commercial Bank Deposits ($Trillions)
Money Market assets jump for second straight week. The Investment Company Institute’s release of money market fund assets for the week ended March 22 showed the second consecutive week of outsized (2%+) increases. Figure 3 illustrates the discontinuity caused by the banking crisis.
Figure 3: Money Market Fund Assets ($Trillions)
Credit remains benign (so far). While the initial wave of panic around liquidity looks like it may be receding, the main thing that gives us pause is credit, which has remained benign. We are seeing signs of fraying, particularly in commercial real estate and auto, but they haven’t begun to really impact results yet. One naturally hopes for a soft landing, or at worst, a short and shallow recession, but we are left with the concern that the level of capital which a downturn will reveal to have been misallocated may prove as historically unprecedented as the duration of ZIRP was.
Figure 4: Credit Quality Remains Benign
What We’re Watching
Figure 5: Bank Crisis Calendar, Week of March 27
In No Particular order:
Credit ratings and metrics. We continue to watch for further action by ratings agencies, of course, as well as spreads on bank debt and credit default swaps.
Key weekly data points. As covered above, weekly FRB releases covering the Fed balance sheet, and aggregate US bank balance sheet, as well as the Investment Company Institute’s weekly Money Market Fund Assets release.
Washington. The coming week will see the first hearings on the current crisis; FDIC Chairman Martin Gruenberg, FRB Vice Chairman for Supervision Michael Barr, and Treasury Under Secretary for Domestic Finance Nellie Liang will testify before the Senate Banking Committee on Tuesday morning, and the House Financial Services Committee on Wednesday morning.
They have much to discuss.
To the extent that the hearings are a post-mortem, then beyond the question of why SVB Financial was permitted to manage its interest rate risk so poorly for so long, it may be worth looking for other red flags that may have been missed. Posts by a verified Twitter account seemingly held by a former SVB Financial customer, shown in Figure 6, raise the question of whether part of SVB’s appeal to the VC ecosystem was a willingness to behave recklessly in areas beyond asset-liability management.
Figure 6: Silicon Valley Bank may have mishandled more than just interest rate risk
Meanwhile, the failure of Signature Bank is an invitation to demagogy on the subject to cryptocurrencies. Opponents of the technology must reckon with the fact that banks with no exposure to digital assets have proven equally susceptible to runs this month, while supporters must accept that the volatility demonstrated by crypto-linked deposits (even if such volatility reflects the industry’s current, immature stage of development rather than any intrinsic attribute of the market, which is a very defensible position) can, if not properly managed, exacerbate liquidity concerns, and thus demands legislative and regulatory scrutiny.
Away from the hearings (or perhaps at them as well), reports indicate that regulators are contemplating additional forms of support for banks if required by First Republic or the broader banking system, and while administration messaging hasn’t been entirely consistent, some wider guarantee of depositors seems to have support. We also await details on (presumably inevitable) changes to regulatory standards, in formal quantitative requirements, stress testing, and generally heightened regulatory scrutiny, including for banks whose size has hitherto exempted them from the most burdensome regulatory requirements.
First quarter earnings. We are now three weeks away from the start of banks’ first quarter earnings releases. JP Morgan Chase, Wells Fargo, Citigroup and PNC all scheduled to release on April 14, and we note that in recent years, First Republic has also been in the habit of releasing results on the first day of earnings season, though no date has been announced for April.
Longer Term Effects: Energy Finance
Accelerating Europe’s exit? The liquidity crisis has sprung up so quickly that relatively little thought has been spared for longer term and second order effects, but there may be significant ones. Over the weekend, energy analyst Arjun Murti, probably best known for his work while at Goldman Sachs, penned a characteristically thoughtful essay suggesting that the collapse of Credit Suisse will accelerate the slide of Europe’s financial sector into irrelevance to oil and gas finance. He also asks whether large U.S. banks will, over time, follow suit–a question which implicates the regional banks at the center of the current crisis in the U.S.
G-SIBs vs oil-patch regionals. Even if banks in New York and San Francisco declined to finance oil and gas, one might reasonably expect oil patch banks to continue financing an industry so important to the local economy. The problem, we note, is that those banks aren’t very big, for reasons that harken back to another intersection of the global oil market and the American banking system.
In late 1985, after years of reducing their oil production while watching other OPEC countries fail to honor their agreed-upon quotas, the Saudis apparently decided that tough love was in order and ramped up their production, predictably resulting in a glut. Between late 1985 and mid-1986, the price of oil collapsed, and took the Texas economy–and then-large Texas banks–with it. Had Saudi forbearance lasted just a few more years–had oil prices collapsed after the U.S. real estate market in the 1980s, rather than before–then the primary locus of consolidation of the banking system would very likely have been Texas rather than North Carolina. New York and San Francisco would still be the nation’s primary and secondary financial capitals, but the tertiary one would be Dallas or Houston. Texas would be home to its own G-SIB(s), and Charlotte would be just another southern city that used to have a lot of banks, like Richmond, Virginia, or Birmingham, Alabama. But they didn’t, and it isn’t.
As a result, the largest banks based in the oilpatch today are mid-cap regionals, and while many have a great deal of in-house expertise in energy finance, their balance sheets can support only so much activity, and they have limited capital markets operations. BOK Financial is a good example; energy loans account for 15% of the bank’s total loan book, it has deep experience and expertise in the sector, and it is difficult to imagine George Kaiser’s bank deciding to exit oil and gas lending. Yet the bank’s total assets are $48 billion–not small it is just not large enough to fill the shoes of any global banks that cease underwriting oil and gas. Tying BOK Financial back to the key factors in the current crisis, at year-end the bank’s held-to-maturity securities losses were relatively modest–$200 million on a tangible equity base of $3.6 billion–but uninsured deposits of $21.3 billion represented 61% of total deposits. To be clear, that’s a far cry from the levels at SVB Financial and Signature, but as of this month, it is a risk factor that customers (and investors) no longer enjoy the luxury of disregarding.
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