The Big Idea

Lessons learned from banking in 2023

| December 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.

Several of the traditional measures of bank stability showed their flaws after the bank failures of 2023. Regulatory capital proved inadequate, and tangible capital adjusted for losses in held-to-maturity securities provided a more accurate view of a bank’s solvency cushion. Loan-to-deposit ratios should now also include held-to-maturity securities for a more complete picture of a bank’s illiquid assets.  Deposit balances above the FDIC’s insurance limit should get additional scrutiny. And larger cash balances should now be viewed positively. The lesson here is that everyone needs a sharper picture of bank balance sheets.

Capital ratios adjusted for securities portfolio losses should take priority

Looking at capital ratios with risk-weighted assets as the denominator is a helpful start when thinking about a bank’s capital position. But these ratios have shortcomings that became evident during the bank failures of spring 2023.  For the most part, these ratios ignore the impact of changes in the value of a bank’s securities portfolio.  Banks below $700 billion in assets have had the ability to exclude any negative mark in their available-for-sale (AFS) securities portfolios, shielding their capital ratios as rates moved higher in 2022 and 2023.  Banks above $700 billion in assets have not had this luxury, and consequently have designated a much higher percentage of their portfolios as held-to-maturity (HTM), or, as one bank client calls it, hide-to-maturity.  For the group of banks tracked by Santander US Capital Markets, banks above $700 billion in assets had a median HTM securities portfolio allocation in the third quarter of 2023 of 66%, whereas banks below $700 billion were only 36% HTM (Exhibit 1).  The Basel III Endgame rule proposals would remove this AFS benefit for banks with assets between $100 billion and $700 billion.  These banks may be inclined to increase their HTM allocation, but liquidity will continue to be the primary consideration going forward and expect banks to lower HTM.

Exhibit 1:  Held-to-maturity securities portfolio allocation should decline

Source: S&P Global, Santander US Capital Markets

Tangible common equity (TCE) ratios capture the impact of these AFS portfolio market value movements, and therefore are a step in the right direction for determining a bank’s economic capital position. TCE ratios, however, still ignore the impact of HTM portfolio market value changes, so an HTM-adjusted TCE ratio is the most accurate measure of a bank’s actual capital position (Exhibit 2).

Exhibit 2:  HTM-adjusted Tangible Common Equity ratios, third quarter 2023

Source: S&P Global, Santander US Capital Markets

For the median bank in this group, their TCE ratio would be adjusted down by 1 percentage point if HTM marks were included, and some banks would see as high as a 4-point adjustment.  Obviously, these negative marks are interest rate related and not credit-driven, so the losses will not be realized as long as the bank has the ability to hold those bonds to maturity.  A severe liquidity shortfall such as that experienced by SVB would result in the sale of these bonds, where unrealized losses become realized.  When those losses exceed capital, the bank is insolvent.

Liquidity positioning draws additional scrutiny

Historically, a bank’s loan-to-deposit ratio provided a useful snapshot of a bank’s liquidity position. A ratio of around 90% was an indication of a healthy balance of good loan origination capability and therefore good earnings, but also enough other liquid assets to weather unexpected volatility. The bank failures of 2023 highlighted the shortcomings of this ratio. SVB had a disproportionately large securities portfolio with much of this accounted for as HTM. First Republic’s securities portfolio was not very large but was also heavily weighted toward HTM—not ideal when coupled with a large loan book.  Therefore, it is more instructive to add HTM securities to loans as a proxy for total illiquid assets, and then divide that total by deposits (Exhibit 3).

Exhibit 3:  Illiquid assets ratio: Loans + HTM divided by deposits

Source: S&P Global, Santander US Capital Markets

These ratios have been relatively static throughout 2023 as both securities portfolios and HTM allocation have declined, but those factors have been offset by deposit outflow. These numbers should come down over the coming months as deposits stabilize and HTM allocation declines.

Also, a bank’s amount of uninsured deposits now are an important factor to consider when evaluating a bank’s liquidity position.  Deposit amounts over the FDIC insurance limits should be assumed to have shorter durations than amounts below the limits, and banks should work to reduce these uninsured deposit amounts where possible. For group of banks tracked, the percentage of uninsured deposits has been managed down from a median of 56% at the end of the first quarter 2023, around the time of the start of this year’s failures, to a median of 54% at the end of the third quarter.

Exhibit 4:  Uninsured deposit percentage

 Source: S&P Global, Santander US Capital Markets

Even with all of the proposed regulatory changes released this year targeting capital, long-term debt issuance and resolution planning, additional liquidity proposals are still forthcoming. While the specifics of these proposals are unknown, a focus on some of the factors that drove the 2023 bank failures is expected:  limits on uninsured deposits as a percentage of total deposits, limits on uninsured deposit duration, limits on HTM securities portfolio allocation, and the ability to demonstrate securities portfolio liquidity through additional repurchase lines that are tested more frequently.  In the interim, cash is king (Exhibit 5).

Exhibit 5:  Cash equivalents to total assets

Source: S&P Global, Santander US Capital Markets

For this group of banks, deposit outflow continues but has moderated, and therefore cash balances have stabilized at a median of 7% of assets.  Whereas an oversized cash position may have historically been viewed negatively as undeployed capital and a drag on earnings, greater cash holdings should now be viewed positively as a great source of liquidity.  Assuming deposit outflow continues to moderate, banks should start to build their cash positions to a higher percentage of assets.

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

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