The Big Idea

Timing the return of bank portfolio investing

| September 15, 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.

Banks are navigating a slew of regulatory proposals on capital and funding with more rules on liquidity likely on the way. All of this comes against a backdrop of restrictive Fed policy with rates massively higher over the last 18 months and a shrinking Fed balance sheet. And fluctuating loan demand has affected banks, too. These factors have sidelined bank investment portfolios for months, and the magic question is when these heavyweights might return to the ring. Regulatory clarity and easier Fed policy expected in mid-2024 should be catalysts for a more measurable return of bank portfolios to the securities markets.

Needed: Easier Fed policy

Any thought of banks returning to significant securities portfolio investment starts with an end to the Fed’s tightening cycle and perhaps the beginning of some easing.  Not only should this help to stem the outflow of deposits, but it should also reduce worries of potential future portfolio losses due to higher rates. Since the Federal Reserve started aggressive tightening in March 2022, banks have only slowly raised deposit rates to keep interest expense low. Before Silicon Valley Bank’s collapse, banks had been happy to allow deposits that flowed in during pandemic to run-off. Banks consequently increased deposit rates only modestly. The bank failures of 2023 woke up the remaining sleepy depositors who had not been paying attention, accelerating deposit outflow and reducing bank cash balances more rapidly.    Looking at Fed Funds futures, the market is currently expecting the Fed to hold at current levels and potentially start easing in the middle of 2024 (Exhibit 1).

Exhibit 1:  An end to rate hikes is the first step toward deposit stabilization

Source: Bloomberg, Santander US Capital Markets LLC

In addition to the Fed’s interest rate policy, Quantitative Tightening (QT) has also played a role in bank deposit outflow as the supply of cash in the financial system decreases.  Since the recent peak in early 2022, the Fed SOMA has declined by about $1 trillion. The ongoing pace of QT could also impact the stability of deposits.  An end to QT—a 2024 event at the earliest—would help banks get clearer expectations of their likely deposit balances.

Since the tightening cycle began in March 2022, the entire US banking industry has seen $792 billion of deposit outflow through the end of August 2023.  Individual bank deposit flows for the Sander US Capital Markets tracking group in the second quarter of 2023 is shown below (Exhibit 2).

Exhibit 2:  Deposit flow second quarter 2023

Source: S&P Global, Santander US Capital Markets LLC

To stem the tide of this deposit outflow, banks have been progressively increasing their deposit betas, which is the percentage of the increase in fed funds that banks pass through to depositors.  At the beginning of the tightening cycle, marginal betas for the first and second quarters of 2022 were below 20% but have been increasing since, with a material spike in the second quarter of 2023 to 98% (Exhibit 3).

Exhibit 3:  Banks fight deposit outflow with progressively higher rates

* Rate shown came into effect on prior date.
Source: S&P Global, Santander US Capital Markets LLC

While some of this deposit outflow has been replaced by wholesale borrowings, there has also been a significant reduction in cash balances at many banks.  With most banks pausing any portfolio reinvestment over the past few months, there is a general perception in the market that banks have been hoarding cash, and while this may true for a handful of banks, the overall Santander US Capital Markets tracking group saw a decline in cash balances on both an absolute basis and as a percentage of total assets.  This group of banks saw cash decline by $221 billion in the second quarter of 2023, and from 8% of assets to 7% as shown below (Exhibit 4).  The expectation is that, following the bank failures earlier this year, most banks will want to, or be required to, carry larger cash positions going forward, and this cash build has not even started for many banks.

Exhibit 4:  Wholesale funding falls short of replacing deposits, cash drains

Source: S&P Global, Santander US Capital Markets LLC

Needed: Regulatory clarity

Mark the calendar for mid-2024 when regulatory clarity and an easier Fed policy may collide to ignite bank portfolio buying.

The third quarter of 2023 has been a regulatory proposal bonanza, with almost 1,100 pages focused on capital released in July and nearly 600  pages focused on long-term debt issuance and resolution planning requirements released in August.  And if this was not enough, some market participants are expecting additional rules with specific liquidity requirements to be released in the fourth quarter in conjunction with the annual horizontal liquidity review.

While some banks may be starting to selectively replace portfolio run-off, most will at least want to see the new liquidity proposals before making large securities investments that could possibly need to be unwound in relatively short order if the rules are more severe than expected.

For the new capital and long-term debt rule proposals, comments are due November 30 with final rules expected in July of 2024.  Compliance with these rules would then generally need to begin July 2025 with some features phased-in over three years, but banks have historically moved more quickly toward full compliance once the final rules are known.

Needed: Clarity on loan demand

Bank securities portfolios, while serving as a source of liquidity for a bank, also tend to be the counterbalance to loan production. Periods of low loan growth such as 2020 and 2021 led to growth in securities portfolios, while the post-pandemic surge in loan growth in 2022 led to portfolio declines.  This loan growth was stifled by the bank failures of 2023 but remains positive. The proposed regulatory changes requiring additional capital, as well as a weaker economic backdrop, would likely further dampen bank appetite for new loan production.  However, an unexpected spike in loan demand would cut into potential future securities portfolio purchases.

On a related but separate note, securities portfolio duration could extend

Some of the changes discussed above would result in a shortening of overall balance sheet duration.  This is known as Duration of Equity (DoE), where overall liability duration is subtracted from overall asset duration to derive an estimate of Economic Value of Equity (EVE) change for an instantaneous, parallel shock of interest rates.  For example, if DoE was 3 and rates increased by 100 bp, and if the entire balance sheet was marked-to-market, equity value would decline by 3%.  While the entire balance sheet is not marked-to-market from an accounting perspective, these estimates of EVE losses are tracked by regulators and an important part of a bank’s overall asset-liability management analysis.

The expected future build-up of cash at the expense of the securities portfolio will result in a shortening of DoE, where assets with duration of usually several years would be replaced with assets having effectively zero duration.  Additionally, the long-term debt requirement proposal includes provisions where the bank starts to lose credit when the debt maturity is inside of two years.  Therefore, it seems unlikely that banks would issue three-year debt that could quickly start to lose credit, and would be more likely to issue five-plus year maturity unsecured debt.  This will be replacing other wholesale funding alternatives such as repo and FHLBank funding, or uninsured deposits, all which would have shorter durations than unsecured debt.  Here again, DoE will shorten.

Perhaps banks will look to run shorter duration balance sheets going forward and will allow that DoE number to stay shorter permanently.  Here, the bank will at least need to continue to invest in agency mortgage pass-throughs and other such long duration bonds to keep their DoE from shrinking any further.  And if we do find ourselves in a declining rate environment in 2024, banks may want to extend duration to reduce asset sensitivity and improve their earnings profile in those rate scenarios.  These circumstances may result in banks running smaller, but longer-duration portfolios going forward, with DoE’s no longer than where the banks are starting from now.

Tom O'Hara, CFA
1 (646) 776-7955

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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