The Big Idea

Out-of-consensus calls on bank balance sheets in 2024

| November 17, 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.

Feedback from a wide set of banks suggests that many management teams expect rates to stay higher-for-longer next year without Fed cuts dominating the market. The banks also believe that they have put aside more than enough reserves for credit risk in recent years as the consumer has remained resilient. And with commercial real estate being the exception, banks are not expecting material increases to reserves in 2024. Finally, with new capital proposals driving an expected decrease in lending, new guidance from regulators regarding balance sheet optimization alternatives should allow banks to continue to originate and hold many of the loan products that they portfolio today. These things look likely to take bank balance sheets in some new directions next year.

Banks look likely to show a few new twists in 2024:

  • Reducing balance sheet duration and becoming more asset sensitive
  • Keeping provisions for credit loss low, except for commercial mortgages
  • Issuing more credit-linked notes

Banks reduce balance sheet duration to add asset-sensitivity

Banks had started to add balance sheet duration in early 2023 as recession and lower rates had been broadly expected.  Balance sheet duration may be measured by looking at a ratio which is the one-year gap to total assets – floating-rate assets less floating-rate liabilities divided by total assets.  When a bank adds balance sheet duration (otherwise known as duration of equity) by extending asset duration or reducing liability duration, the bank is positioning to outperform on net interest income and earnings when rates decline.

The high-profile bank failures from the first half of 2023 were somewhat driven by losses on longer-duration assets, particularly in the cases of Silicon Valley Bank and First Republic Bank. This forced banks to slow or completely stop their duration add and generally pause on securities portfolio purchases.  Accelerated deposit runoff at many banks also made larger cash holdings more desirable.

The very early signs of this higher-for-longer sentiment from banks is starting to appear, with the one-year gap to total assets – after declining for several quarters, reversed course and started to head higher in the third quarter of 2023 (Exhibit 1).  For this group of banks, the median ratio moved from 26 in the first quarter down to 24 in the second quarter, and then up to 25 in the third quarter of 2023.  This trend is starting to become apparent for some banks such as U.S. Bancorp, which issued $6.5 billion of new fixed rate debt this year through October compared to only $3.8 billion of maturities (at U.S. Bank), and also continued to add hedges to reduce the duration of their available-for-sale securities portfolio.  Western Alliance Bank (WAL) is also adding to their asset sensitivity by increasing their cash holdings on the asset side and increasing their longer-duration non-maturity deposits on the liability side of the balance sheet.

Exhibit 1:  Banks stop duration add, start to increase asset-sensitivity

Source: S&P Global, Santander U.S. Capital Markets

Bank derivative usage is starting to increase. One way banks are able to achieve this greater asset-sensitivity is through the addition of pay-fixed swaps, where the bank is effectively able to convert fixed-rate asset coupons to floating-rate.  Banks are less likely to add significant securities portfolio duration going forward, and without this large buyer in the mix who historically accounted for about a third of MBS demand, expect this asset class to remain cheap for the foreseeable future.

Provisions for credit losses remain low (except for commercial mortgages)

Along with an expectation of a recession typically comes concern for deteriorating credit of businesses and households.  Contrary to this view, at the Santander U.S. Capital Markets’ recent Bank Roundtable Dinner, the consensus view of the treasurers, chief investment officers and portfolio managers in the room was that banks have been over-reserving in recent years.  This is somewhat due to newer Current Expected Credit Loss (CECL) rules which became effective for public companies in 2020.  Except for commercial real estate loans, this group felt that credit provisions would not materially increase in 2024.  Indeed, there have only been modest increases in provisions so far in 2023 (Exhibit 2).  The median for this tracking group has remained fairly contained, at 29 bp, 34 bp and 40 bp of average loan size for the first quarter, second quarter and third quarter of 2023, respectively.  Banks with large credit card and auto concentrations have generally seen larger increases in provisioning.  It is notable that one of the largest credit card banks, Capital One (COF), has actually posted lower provisions in each of the last two quarters.  Given the bullish bank sentiment around the consumer, investments in subordinated tranches of asset-backed securitizations or credit-linked notes could be expected to perform well from a credit perspective.

Exhibit 2:  Credit provisions have increased only modestly in 2023

Source: S&P Global, Santander U.S. Capital Markets

Banks issue more credit-linked notes

Basel III endgame regulatory proposals released in July are estimated to increase bank capital requirements by 5% – 19%.  Advanced approach internal modeling of risk-weights is generally going away and incremental capital for operational risk and counterparty risk may be required.  This is broadly expected to result in some banks exiting certain lending businesses.

In late September, however, regulators released some much-awaited guidance on the structuring of synthetic securitizations – often referred to as credit-linked notes (CLNs) – under Regulation Q (Capital Adequacy of Bank Holding Companies, Savings and Loan Holding Companies, and State Member Banks).  CLNs allow loans to remain on a bank’s balance sheet, while junior credit risk of the portfolio is transferred to third party investors.  This risk transfer generally results in a bank being able to reduce its capital requirements for a given portfolio by 60% – 80%.  These transactions are much more frequent and common in Europe given the clear regulatory guidance in that jurisdiction, while confusion in the U.S. has kept most banks on the sidelines.  This new guidance should now change this.

Regulators prefer that the structure incorporate a special purpose vehicle (SPV) to receive the investors’ CLN cash proceeds.  The bank would then have a credit derivative with the SPV as the mechanism to receive cash to cover any credit losses on the reference portfolio.  This structure has generally not been used in the U.S. in the last decade following the implementation of the Volcker Rule.  This rule says that an entity sponsoring an SPV along with a credit derivative could result in the entity being deemed to be a commodity pool operator, subject to regulation by the CFTC.  This is a risk that banks do not wish to assume, so CLN structures in the U.S. in recent years have not included an SPV and have instead been issued directly by the bank (Exhibit 3).

Exhibit 3:  Direct bank-issued CLNs

Source: Santander U.S. Capital Markets

The September guidance noted that regulators don’t believe this structure meets the synthetic securitization requirements as the investors’ cash is not viewed to be collateral for a credit derivative.  Instead, the cash is viewed as bond proceeds and property of the bank.  Still, the regulators are acknowledging that this structure is effective in transferring risk, and therefore are allowing (almost inviting) banks to request a reservation of authority under the capital rule for directly issued CLNs.  This would allow a bank to assign a different risk-weighted asset amount to the reference exposures.  A small handful of banks have already requested and received this approval.

Certainly, there will be banks that are more constrained by their leverage ratio than a risk-weighted assets driven capital ratio, and those banks will need to sell assets.  In most cases, these assets would be loans with fairly attractive yields, and their disposition will negatively impact net interest income and earnings. But for banks that have the latitude to keep the assets on balance sheet and are instead looking for a risk-weighted assets reduction, CLNs offer an excellent alternative where the bank is able to keep most of the earnings from the loan portfolio while greatly reducing the capital requirement.  Given currently depressed bank equity prices, increasing the capital ratio numerator is a bad option, so reducing the denominator will be the way forward for many banks.

Investors should expect to see ample opportunities to invest in CLNs over the coming months and years for a variety of asset classes including residential mortgages, auto loans and commercial and industrial loans.

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

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