The Big Idea

Banks see shifts ahead in rates, cash, risk and more

| October 13, 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.

Rates rise and stay there. Recession arrives in 2024. Banks stockpile cash and limit their interest rate risk. Smaller banks push more securities into held-to-maturity accounts. Securitization plays a bigger role, mortgage lending a smaller one. And more banks merge. All of these views emerged as Santander US Capital Markets hosted its second annual Bank Roundtable Dinner in New York where GSIBs, super-regional and regional banks, community banks and credit unions participated in a spirited discussion of the issues and challenges they are currently facing.

The Fed, interest rates

The general consensus of the room was higher-for-longer interest rates.  One participant cited recent comments from Fed Governor Waller that higher market interest rates may help the Fed to slow inflation and would factor into the Fed’s decision as to whether rates needed to be raised again or not.  A couple participants cited no expectation for rate cuts next year, with the caveat that some of the recent geopolitical turmoil could escalate and create headwinds that start to have a negative impact on the broader economy.

Recession, credit risk

No soft landing. Participants are expecting more stress on the economy in early to mid-2024 (‘recession imminent’), although many noted the resiliency of the consumer and the fact that depositories have generally over-reserved for credit risk for several years, so no expectation for large increases in provisions.  Away from the consumer, commercial real estate was noted as the primary concern from a credit perspective.

Cash holdings

Banks are generally expecting to have higher cash balances and smaller securities portfolios going forward to fortify their liquidity positions.  With deposits still flowing out of banks, cash positions are overall lower than earlier in 2023, both on an absolute basis and as a percentage of total assets.  This cash will need to be replenished, and then the incremental cash build will begin.  A steeper yield curve at some point, making securities investing more attractive, could temper the desire to build cash.

For smaller community banks and credit unions with more retail-concentrated deposit bases, liquidity has not been as great of a concern.  These institutions are not expecting to increase cash given the drag on earnings that may create.

Duration risk management

Larger cash holdings in lieu of securities, as well as proposed long-term debt requirements for some banks, will result in a lower overall duration of equity.  The general consensus in the room was that banks would not seek to manage this by extending duration in their securities portfolios, and will instead manage this through derivatives, such as adding a receive-fixed swap as a hedge to an unsecured debt issuance in order to convert the coupon to floating rate.

Held-to-maturity accounting

The regulatory proposal to remove the Accumulated Other Comprehensive Income (AOCI) filter for banks between $100 billion and $700 billion in assets, which shields regulatory capital from the negative mark-to-market of the available-for-sale (AFS) securities portfolio, has many market participants believing that there will be an increase in HTM allocation going forward.  This was another question where the answer varied based on the size of the institution. The larger money-center and trust banks already have high HTM allocations and thought these numbers may decline going forward given heightened liquidity concerns.  Some felt that HTM accounting was flawed in that it did not allow an institution to hedge the securities and thereby actually increased the economic risk.

Mid-sized and smaller depositories generally have lower HTM allocation currently and some noted that they would modestly grow HTM going forward.

Private-label securities: MBS, CMBS, CLOs

While these products carry wider spreads and higher yields, the relative illiquidity of these positions weighs heavier on the purchase equation and depositories are not likely to increase their allocation to these products.  The new regulatory proposals would lower the risk-weight floor of senior tranches from 20% to 15%, but the participants did not view this as enough incentive to grow allocation.  Also noted was the proposed change to double the ‘p-factor’, which is part of the regulatory formula to calculate the risk-weighting of various structured product tranches.  Some participants noted this p-factor change would significantly increase the risk-weighting of double-A and single-A tranches, and their preference would be for the regulators to keep the risk-weight floor at 20% and the p-factor at its current 0.5.

Balance sheet management strategies

Expect to see an increase in various balance sheet management strategies to accomplish different objectives.  Already starting to see an increase in regular-way off-balance sheet securitizations, where the entire capital stack is sold and the assets are completely removed.  This helps to reduce to overall balance sheet size and leverage.  Also seeing a form of capital relief trades which are seller financing, where a bank sells a portfolio to an investor, the investor securitizes the loans, and the bank buys back the senior securities.  This effectively reduces the risk-weighting of the asset from 50% or 100% down to 20% for the senior tranche.  Both of these structures result in an accounting sale and a resulting gain or loss, which works for newly originated collateral but is more problematic for more aged loans carrying lower coupons and a discount dollar price.

For discount collateral, credit-linked note synthetic securitizations don’t reduce balance sheet leverage but can reduce regulatory capital requirements, and recent clarity provided by the Fed should increase the volume of these deals.

Residential mortgage lending

Proposed new risk weightings for residential mortgage lending would result in a moderately larger capital requirement for portfolio holdings, but due to the new operational risk component which penalizes fee-based businesses, there would be a significantly higher capital charge for conforming loans sold to the GSEs as gain-on-sale would be included as a fee. Non-bank originators already account  for 75% of Fannie Mae and Freddie Mac production, and this number would increase substantially under the new proposals.  Participants noted that mortgage lending has always been a difficult business for banks given the negative convexity of the product and the fact that banks are already short convexity in their deposits.

Participants felt that the regulators were pushing certain businesses out of the banking system to non-banks, but that banks are lenders to the non-banks, and therefore the instability of non-banks ultimately comes back to the banks anyway—albeit it as a secondary exposure with a haircut cushion instead of a primary exposure.

Bank mergers

Participants believe that there could be more failures if rates continue to rise, and that regulators will facilitate acquisitions in these scenarios.  Away from failures, but for more regular-way mergers that look to achieve cost efficiencies, participants felt that regulators would be accommodative as they would prefer to have fewer banks in the system in the US and the merged entity would likely be more profitable and stronger going forward.

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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