The Big Idea

A midterm exam on banking

| July 14, 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.

The unexpected bank failures of March this year have added a new twist to the likely path of bank balance sheets. Until then, it was all about the economy and the Fed’s efforts to cool it down. But March will likely mark a turning point for this year and well beyond. New regulatory proposals seem imminent, likely requiring banks to increase their overall liquidity and further diversify their sources of funding. That should show up in loans, securities, deposits, wholesale funding and balance sheet interest rate risk, just to name a few.

Loan growth stalls

While robust loan growth had continued into March, the failures of Silicon Valley Bank and others has forced banks to pause and consider deleveraging their balance sheets. Loan balances have generally been flat since mid-March, and this trend should continue for the remainder of 2023 as banks wait for and then respond to new regulatory proposals dictating a higher liquidity requirement (Exhibit 1).

Exhibit 1: Bank failures stunt loan growth

Source: Federal Reserve H.8 as of 6/21/23 Table 2 – Line 9, Santander U.S. Capital Markets

Fewer loans means lower net interest income and earnings, which may lead to banks expand their credit box into new, higher margin territory. Home equity loans and lines of credit, which carry higher interest rates than first-lien mortgage production, should get a lift in production from the massive amount of home price appreciation the country has seen since the start of the pandemic. Banks may also be tempted to move down the credit spectrum to lower quality auto loans or transitional real estate.

And while banks may change their lending mix while looking to slow loan growth overall, there will be more opportunities for private credit funds to step in and fill the void. This has already started to occur with some of the bank deleveraging that started in March.

Securities continue to decline, cash increase likely to be long-term

Since March, banks have generally not been reinvesting portfolio paydown and instead have been hoarding cash (Exhibit 2). Cash balances had actually declined by 4.4% year-to-date just prior to SVB’s failure, and since have reversed and increased by 15%, a net increase of over 7% year-to-date.

Exhibit 2: Expected regulatory proposals likely to keep cash balances higher

Source: Federal Reserve H.8 as of 6/21/23 Table 2 – Line 29, Santander U.S. Capital Markets

Securities portfolios had been leaking lower early in the year as loans continued to grow, with the steep drop in March resulting from the failures of SVB and Signature when their securities portfolios of $114 billion were assumed by the FDIC and removed from the Federal Reserve H.8 reports. After these failures, portfolios have resumed their steadier march lower due to both loan growth and larger cash positions (Exhibit 3). Portfolios were down 1.7% year-to-date just prior to SVB and Signature, and since are down another 4.1% for a total dip of around 5.8% through late June.

Exhibit 3: Securities portfolios dip significantly lower post bank failures

Source: Federal Reserve H.8 as of 6/21/23 Table 2 – Line 2, Santander U.S. Capital Markets

Securities portfolios, in addition to being smaller going forward, are likely to also have shorter durations. Regulators will want to see that securities are a genuine source of liquidity when needed to help fund deposit outflow, and therefore the use of held-to-maturity accounting is also likely to decline. Shorter duration agency MBS and CMBS are likely to become more prevalent, while longer-duration MBS will likely become less expensive with banks stepping away and should present opportunity for non-bank buyers (Exhibit 4).

Exhibit 4: Shorter-duration agency RMBS & CMBS alternatives

Source: Bloomberg, Santander U.S. Capital Markets

Deposits continue to decline, wholesale borrowings grow

Deposits dropped precipitously after the SVB collapse (Exhibit 5). And the general move lower since is likely to continue as the failures put a spotlight on low deposit rates and send depositors in search of higher-yielding alternatives. As of March 31, for the group of banks tracked by Santander US Capital Markets, the median bank was paying 1.72% for interest-bearing deposits, which was still over 250 bp lower than fed funds and the largest differential in over a quarter century.

Exhibit 5: Depositors continue to seek higher-yielding alternatives

Source: Federal Reserve H.8 as of 6/21/23 Table 2 – Line 34, Santander U.S. Capital Markets

With deposit outflow accelerating, wholesale funding rapidly needed to increase to fill the gap (Exhibit 6). Over two weeks in mid-March, borrowings increased by a whopping 29% or $570 billion. Much of this came from the FHLBanks, with lesser amounts borrowed from the Federal Reserve discount window and term facilities.

Banks are continuing to pursue diversification of funding and replacing some of this new borrowing with securities repurchase agreements, unsecured debt issuance and securitization. More repo lines will be needed, and regulators are expected to require more frequent usage of these lines, and for a wider variety of securities that banks have in portfolio. All of these forms of funding are currently more expensive than deposits, which will lead to compressed earnings. In addition to needing unsecured debt issuance to replace deposit runoff, many regional and super-regional banks will also need to issue more debt to comply with higher Total Loss Absorbing Capital (TLAC) requirements, further pressuring bank debt spreads for the foreseeable future. Regarding securitization, in addition to traditional GAAP sale structures, there will likely be more use of non-GAAP sale financing structures, where only senior bonds are sold and no gain or loss is realized. After several hundred basis points of rate hikes, this will be a useful tool to help banks unlock liquidity in their loan assets.

Exhibit 6: Borrowings spike to replace deposit outflow

Source: Federal Reserve H.8 as of 6/21/23 Table 2 – Line 37, Santander U.S. Capital Markets

Asset-sensitivity to level off

As the market had broadly expected a recession and lower rates in 2023, banks started to add duration to reduce their asset sensitivity, measured in part by the amount of asset coupons resetting relative to deposits. This had started in the first quarter of 2023, with the median bank in the Santander US Capital Markets tracking group reducing the ratio of 1-year gap to total assets—assets with coupons resetting within one year, less liabilities with coupons resetting within one year, divided by total assets—from 28% in the fourth quarter of 2022 to 26% (Exhibit 7). After the bank failures, banks quickly reversed course and stopped adding long duration with the expectation that regulatory proposals may require such a change. Also, with the Fed expected to hike in July and perhaps one more time in 2023, banks are settling into their current asset-liability management profiles and are not likely to reduce asset-sensitivity much further. As mentioned earlier, this will create an opportunity for non-banks to buy cheaper, longer duration assets such as pass-through MBS and residential mortgage loans.

Exhibit 7: Banks slow reduction in asset sensitivity as the Fed continues to tighten

Source: Santander U.S. Capital Markets

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

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