The Big Idea
Liquidity in the banking system
Stephen Stanley | May 12, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
A select group of midsized banks suddenly found themselves strapped for deposits early this year with Silicon Valley, Signature and First Republic ultimately unable to survive. Other banks continue to fight to survive in the face of deposit flight. From an economics perspective, I am far less worried about the fate of individual banks than about the health of the banking system as a whole. The aggregate data indicate that there are plenty of deposits in the banking system, which means that while credit conditions will presumably continue to tighten, a destructive credit crunch is unlikely.
From a macroeconomic standpoint, the key question is whether the banking sector has enough deposits to fund the amount of bank lending needed to support the economy. If not, then the US would face a credit crunch.
To tell this story accurately, we have to start in 2020. The federal government divvied out trillions of dollars in stimulus to households and businesses. Much of that money found its way into bank deposits.
Bank deposits surged by almost $5 trillion in 2020 and 2021. The demand for loans did not jump by nearly as much, so banks were awash in deposits. As a result, banks put much of their windfall into securities. Bank holdings of securities exploded by about 50%. From the end of 2019 to the end of 2021, banks’ securities holdings went from $3.8 trillion to $5.7 trillion. Over the same period, bank loans increased from $10.0 trillion to $10.7 billion with the bulk of the rest of the expansion of the asset side of the balance sheet coming in excess reserves.
So, as the Federal Reserve finally began to raise rates above the zero bound in early 2022, banks were more than happy to allow deposits run off since they had more than they could use in the aggregate. Deposit rates have always lagged market rates on the way up, and banks again dragged their heels last year. Even so, many banks found that deposits were actually “stickier” than they expected, which is to say that their customers were keeping their deposits in the bank, yielding minimal returns, even as market rates such as money market yields climbed in tandem with hefty Fed rate hikes.
Some banks that had business models that were particularly vulnerable to higher rates ran into trouble. SVB made a big bet in its securities book that rates would remain historically low. The bank ultimately suffered a run on deposits when customers realized that its unrealized losses on securities holdings threatened its viability. First Republic’s dilemma was somewhat different, as it had underwritten loans to high-quality borrowers at super low rates—reportedly, offering mortgages to ultra-wealthy customers at rates as low as 1%—a strategy that is doomed to prove unprofitable if the bank has to pay anything close to current market rates for deposits to fund the loans.
In the aggregate, however, even as a significant amount of deposits have left the banking system in favor of higher-yielding alternatives like money market funds, deposits over the entire banking system remain unusually large. It is useful to look at bank deposits at year-end as a percentage of GDP going back to 2010 and then for select dates over the past year and a half (Exhibit 1).
Exhibit 1: Bank deposits as a percentage of GDP
By this measure, bank deposits ran in the neighborhood of 60% of GDP prior to the pandemic, spiked to a high of nearly 75% in 2020, and have since receded to about 65% as of March. Still, bank deposits are about 5% of GDP higher than they were prior to the pandemic, which amounts to around $1.3 trillion. This figure should put into perspective the decline in deposits of a few hundred billion dollars since the banking turmoil began in March.
In light of these data, it is hard to imagine that the banking system will suffer from insufficient liquidity to make the loans that the economy requires any time soon. This is especially true given that banks are also sitting on over a trillion dollars more in excess reserves today than they were before the beginning of the pandemic, another of the residual effects of the Fed’s still-bloated balance sheet.
As a result, I am skeptical that we are going to see a broad-based “credit crunch.” Yes, credit conditions are tightening. That is exactly what the Fed has been trying to engineer for over a year, with limited success. As Chair Powell and other Fed officials have underscored, credit conditions were already tightening before March and would be expected to continue to do so, even if the turmoil seen over the past two months had never happened. The question is whether what we are seeing and will see going forward is qualitatively different from the normal cyclical tightening in credit that happens when the Fed is trying to slow the economy. So far, we have not seen enough evidence to know with confidence exactly how the situation is evolving, but I suspect that the economy will continue to have ample liquidity, mainly because the Fed’s balance sheet is still far larger than it should be. The fact that the reverse RP facility continues to collect over $2 trillion daily is prima facie evidence of the massive excess liquidity that continues to pervade the economy.
Having said that, the distribution of bank deposits also matters. If bank depositors were, at the extreme, to take all of their money out of every small- and mid-sized bank in the country and put their funds in a few money center banks, the aggregate level of deposits might be unchanged, but there would be many business and household borrowers who would find it more difficult to procure a loan. It seems like there are some observers who perceive that this is exactly what is happening, but the reality seems much less dire than this. Still, in assessing the credit environment, it will be important to watch the fortunes of community banks, specialty lenders, and other types of banks as well as the aggregate data.
The tightening in credit conditions that began when the Fed started raising rates and picked up speed in March represents a key wild card for the economy. Banks are undoubtedly going to be more conservative for a time in their lending strategies, as they adjust to the fact that their deposits are not nearly as sticky as previously thought. Still, thanks to the slow pace at which the Fed is reversing the massive balance sheet expansion engineered from 2020 to 2022, the economy is still awash in liquidity and is likely to remain so for a considerable period of time. Borrowers will have to get used to paying much higher interest rates for loans, but I expect the banking system to continue to supply adequate funding to the economy.