If you watch the news, or are on social media (and I know you are, or you probably wouldn't be reading this), you've no doubt by now learned that there is a systemic banking crisis underway in the U.S.
Balderdash.
I know, I know - I said this more than six weeks ago, and now another "big" bank has failed, and you're thinking, "Aha! The Curmudgeon was wrong! The media was right!"
Now, I'm not saying I'm never wrong. But I can confidently say that there will never come a day when the media is right and I'm wrong about anything related to the financial system, because there aren't four people in the media who fully understand the financial system, and the vast majority of them don't know a liability from their ass(et).
I heard one pundit on one of the major cable news outlets say, "I don't believe in one-offs, and I certainly don't believe in three-offs." (Referring to the fact that three U.S. banks have now failed this year.)
Well, for the record, neither do I. However, consider this: there are more than 4,000 banks in the U.S. Some of them are poorly managed. Poorly managed businesses may fail. Heck, there are more than 600,000 restaurants in the U.S. and 30% of them will go out of business in their first year. So is there a systemic food service crisis in the U.S.?
Here are the facts (pesky as they are): since 2000, 564 banks have failed in the U.S. That's an average of about 25 banks per year. But it's heavily skewed by the financial crisis of the mid to late 2000s; 25 banks failed in 2008, 140 in 2009, 157 in 2010, and 92 in 2011. From 2012 through 2014, at least 18 banks per year failed, a residual effect of the crisis.
In 2018, 2021, and 2022, not a single U.S. bank failed. Three have failed thus far in 2023. Let's put that in perspective.
In 2020, four banks failed: one in February, one in April, and two in October. Also in 2019, four banks failed: one in May, two in October, and another in November.
Now, in October 2019, when those two banks failed in the same month, do you recall the media and every self-proclaimed financial expert on Facebook screaming at the top of their lungs about a systemic banking crisis? Then redoubling their squawking when yet another bank failed the following month? Then another just three months later, and another two months after that?
The horror.
The fact of the matter is, banks are businesses, and some businesses fail. Three failures out of an industry of 4,000 institutions is a very good track record. Yes, banks are different in that they hold your money. That's why we have deposit insurance. No depositor lost a dime in any of those failures since 2000. In fact, no depositor has ever lost a penny of insured deposits since the FDIC was created in 1933. (You and I, the taxpayers, have seen to that when there's been a crisis, and fortunately those have been very few and far between.)
"But," you say, "it's not just these three banks. The media is saying that there are more banks that could fail."
First, if you haven't learned by now that the media's job is to scare you, with hype and hyperbole, or that they don't have the first foggy notion of what the financial system is all about - well, I can't help you. Look up; somebody painted "gullible" on the ceiling.
Second, yes, there is a list of "problem banks." Guess what? There always has been. The FDIC maintains a list of banks that are rated 4 or 5 on its five-point "CAMELS" rating scale, 1 being best and 5 being brain-dead. (CAMELS stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and interest rate Sensitivity.) I personally saw the list that the savings and loan regulator maintained back in the late '80s when I was an S&L examiner.
Regulators examine the banks, and rate them on those factors. Do they have enough capital to absorb anticipated and unanticipated losses? (In my current job, part of the analysis I perform for my clients is to calculate their capital adequacy in a near-worst-case, 1 in 20 years loss scenario.) Is their asset quality high (meaning, are the loans they make going to repay, or are a large percentage of them likely to default due to poor underwriting and credit management)? Is their management team strong? Do they have sufficient earnings to build additional capital and remain viable? Do they have enough liquidity, including access to contingent liquidity sources (like borrowing from the Fed or other sources, issuing deposits to non-customers through brokers, selling assets, etc.) to ensure they meet ongoing demands for deposit withdrawals and loan growth? And finally, is their balance sheet structured such that they won't incur significant losses - either realized or unrealized - due to interest rate fluctuations?
The C, A, E, L, and S components are largely about risk management, and that's what I advise financial institutions on for a living. And I can tell you that the trends I'm seeing in risk-adjusted capital adequacy and asset quality (loan delinquencies and charge-offs) are sufficiently strong that no one should be losing sleep. And that's across a fairly broad cross-section of clients, from coast to coast and from Texas to northern Ohio. I'll get back to the trends in earnings, liquidity, and interest rate sensitivity momentarily.
The chart below shows the number and combined total assets of banks on the FDIC's "problem bank list." It only goes through 2021, but you get the trend.
We are not spiking back up to 2009 levels this year - not even close. At the end of 2022, there were 49 banks on the list; it actually declined to 46 as of March 31, 2023. Total assets of those institutions on the list were $49 billion. A year ago, there were 54 banks on the list (March 31, 2022).
Now, let's note a few things. First, just because a bank is on this list doesn't mean they're going to fail. They may get new management and come out of the problem situation(s) that landed them on the list to begin with. (That management change may be by their own choice, or forced upon them by the regulator.) Or, they may merge with another, healthier institution that can absorb the problems (the benefits the acquiring institution gets include an expanded customer base, maybe an expanded branch footprint, and possibly additional capital, even if it's meager). There's another way that a bank may come off the list and move up in the CAMELS ratings. I'll address that after we discuss earnings, liquidity, and market sensitivity.
Second, the 46 banks that are on the list today is a number about equal to the 51 that were on the list in 2021, per the graph above. So we're not trending upward in terms of problem banks. In fact, the graph shows that that number has been stable since late 2018, fluctuating between 51 and 60, and much lower than in previous years.
Bank balance sheets today are as strong as they've ever been. Tier 1 capital - core or primary capital that is the foundation of a bank's strength - is higher now than it was a year ago, and since 2020 Q2 it's been above 14% of risk-weighted assets. From mid-2013 through early 2020, Tier 1 capital never got higher than 13.4% of risk-weighted assets. So the banking industry is in a stronger capital position today than it's been in the last ten years. (And note that the denominator is risk-weighted assets, meaning that the value of those assets has been adjusted for their risk according to a formula. So the Tier 1 capital ratio is already adjusted for risk.)
What about asset (loan) quality? The delinquency rate on all loans for all commercial banks in the U.S., aggregated, was 1.19% of total loans at the end of 2022. In other words, 1.19% of borrowers were late on their payments. (That doesn't necessarily mean that those loans will have to be charged off, either. The borrowers may become current on their loans, there could be timing differences in the payments vs. the due date, or the banks may restructure the loans so that the borrower can meet their obligation without default and charge-off. Also, since residential and many commercial loans are collateralized by real estate, the bank can foreclose and sell the collateral. Even with real estate values declining over the last several months, in many cases the lender could make a profit by charging off the loan balance and selling the house, which is probably worth much more at this point than what's owed.)
To put that 1.19% delinquency rate in perspective, it was 7.40% at the height of the 2008-09 financial crisis, and it was 1.60% in late 2020, coming out of the pandemic shutdown. In fact, 1.19% is the lowest delinquency rate for bank loans since the data has been reported, beginning in 1985.
The charge-off rate on bank loans (balances charged off divided by the average balances of loans on the books) was up a bit as of the end of 2022; it was 0.33% of average loans, vs. 0.19% at the end of 2021. That's not a big increase; again, for perspective, the charge-off ratio was 0.55% in mid-2020, and it's currently lower than it's been at any time since 1985, except for the previous seven quarters.
Yes, I know; those are year-end 2022 numbers, and this is 2023, and three banks have failed. So you're thinking there's been some massive spike in bad loans since the end of last year, right? Well, think again. I just finished reviewing the 2023 Q1 financials for all my clients, and the trend I'm seeing is a slight increase in the charge-off ratio (and by "slight," I mean very, very small), but a decline in the delinquency rate.
How can that be, you ask? How can delinquent loans be declining at the same time charge-offs are increasing? Easy - first, there's a lag between a loan becoming delinquent and when it gets charged off. The lender first exhausts all efforts to collect, or restructure the loan so the borrower can become current. Then, if it's a secured loan, they have to repossess and sell the collateral. Only after they've recovered that amount would they charge off the remaining balance, and even then they may send it to a third-party collector to try to recover the funds, in which case at some future date the recovered amounts would offset that period's balances charged off. It takes even longer to foreclose on a house and sell it; in some states the law requires the lender to wait two years before they can foreclose. So today's charge-offs might be the result of loans that went delinquent as much as two years ago.
Finally, there were a number of forbearance programs put in place during the pandemic to prevent lenders from placing borrowers in default status, foreclosing on real estate, and charging off loans. (Brilliant, right? The government shuts down the economy, forcing tens of millions of people out of work. Then, because they can't make the payments on their loans, the lenders have to wait until the forbearance programs expire to collect on the unpaid debt. And you wonder why banks get in trouble.) Those forbearance programs have finally expired, and so some of the charge-offs today represent loans that went delinquent in 2020, but were placed in forbearance.
Okay, it's time to talk about earnings, liquidity, and interest rate sensitivity. Those factors play into the reasons for the failures of the three banks that have been seized in 2023. Earnings are compressed for banks because of rising interest rates. This happens because, as rates rise, they have to raise rates on their deposits, the vast majority of which are demand deposits (savings accounts) vs. term deposits (CDs). So the amount of interest expense they have to pay on those deposits is going up.
At the same time, their loans are longer-term, and mostly fixed-rate. The average auto loan takes about three years to pay off (at which time the borrower either pays off the loan outright, or buys a new vehicle and pays off the loan with the sale of the original vehicle). Mortgages are even longer-term; the average duration of a 30-year mortgage is around ten years. So at the same time their interest expense is going up, most of their interest income is flat.
Let's look at examples. The rate banks pay on 3-month CDs has increased from 0.10% in September 2021 (on average) to 4.91% today. That's a huge increase in interest expense. Meanwhile, the average 30-year mortgage rate in September 2021 was less than 2.90%. So banks are paying nearly 5% on short-term deposits, and they're still earning less than 3% on mortgages booked before rates started going up.
And there are two things preventing them from replacing those 2021 mortgages with higher-earning mortgages (today's 30-year fixed mortgage rate is nearly 6.4%). First, nobody is prepaying those 2021 mortgages. Would you prepay a loan with an interest rate below 2.9%? You certainly can't refinance the loan (unless you desperately need to pull equity from your house, in which case you could just take out a much cheaper home equity loan). And second, there's hardly any demand for mortgage loans today, compared with the last several years. Nobody is refinancing, and home sales have fallen by about 30% since late 2021.
When the interest rates banks must pay on deposits is rising rapidly, and the interest rate they're earning on long-term assets is flat, that's known as a margin squeeze. And the result is a decline in earnings. So banks' earnings, in aggregate, are down compared with the last few years. They can't make it up with fee income, either; the trend in the industry is toward eliminating or drastically reducing most fees. (One of my clients, a large credit union, has eliminated about 70% of its fees over the last two years.) The decline in fees is driven in large part by concerns over actions being taken by the Consumer Financial Protection Bureau (CFPB) (an agency with no oversight, by the way) to assess massive fines against financial institutions for what it deems as unfair fees. And it makes those determinations with impunity.
Liquidity has also been a challenge for banks for the last year or so. From the top down, the Fed has pulled about $300 billion from the market by reducing the size of its balance sheet, after increasing it dramatically to stimulate the economy after the pandemic shutdown. On a more micro level, as rates have risen, depositors have pulled money out of banks and put it into higher-yielding money market funds, or into the stock market. At the same time, demand for loans remained strong through the end of 2022; while mortgage demand began to decline around mid-year, other lending types remained brisk. Many of my clients saw negative deposit growth throughout 2022, and record loan growth. For the credit union industry as a whole, just a small part of the financial institution industry, deposits only grew by 3.3% in 2022, the lowest rate since the 1980s, while loans grew by 19.1%, the highest rate over that same period. In dollars, deposits increased by about $61 billion from 2021, while loans grew by $244 billion. So the industry took in nearly $200 billion less than it lent out. That's a massive liquidity crunch.
Finally, sensitivity to interest rates is always going to be a challenge in an environment in which the Fed increases short-term interest rates by 500 basis points, or five percentage points, in about a year. That hasn't happened since the 1980s, either. The most recent round of Fed tightening (raising rates) has been the most aggressive in nearly half a century.
So those three factors have been a challenge for all financial institutions. Fortunately, the other factors - capital adequacy, asset quality, and management - have been, for the most part, strong enough to counter those challenges, and the industry as a whole is in a very strong position today.
That's not the case for every bank, however. Silicon Valley Bank was poorly managed, and was doomed to fail by its bad decisions, which included a failure to hedge its interest rate risk, which was excessive due to the way it structured its investment portfolio, and a huge concentration of very large uninsured deposits, which are more likely to lead to a liquidity crisis if those depositors start withdrawing their funds. That latter point also plagued Signature Bank. (Here's a recap of those failures: https://theeconomiccurmudgeon.blogspot.com/2023/03/is-banking-system-safe.html).
As for the most recent bank failure, First Republic, it too suffered from severe liquidity stress, and has been on the brink of failure since SVB and Signature Bank went under.
Are there more banks that will fail? Probably, as the trifecta of a margin squeeze, tight liquidity, and interest rate risk will prove to be the undoing of institutions that aren't well-managed (that's four of the six factors of the CAMELS rating system that would be negative, for those institutions). When rates were low and stable and liquidity was ample, those institutions were able to get away with bad management, and took on too much risk. They were incented to do so by the Fed slashing interest rates to zero, which wouldn't have been necessary (and probably wasn't anyway) if the government hadn't shut down the economy due to covid, which definitely wasn't necessary. So, just like the S&L crisis, this situation resulted from government policy.
The good news is that the vast majority of institutions are well-managed. So even though the three factors mentioned above are a challenge for the entire industry, they're not insurmountable.
I promised that I'd mention another way that a bank can move off the FDIC problem bank list after we talked about earnings, liquidity and market risk. And that's to just stay the course until conditions normalize. For many institutions, what put them in the position they're in has been this environment of rapidly rising interest rates and tight liquidity. So when those conditions normalize, those institutions' health will improve.
When will that happen? When we have a recession. The Fed will begin cutting rates, so rates will go down. Combined with home prices reverting to normal, which is already happening, that will make homes affordable again, and mortgage demand will resume. But first, loan demand overall will decline, since people generally avoid borrowing money during an economic downturn, due to uncertainty over their ability to repay if they were to lose their jobs. And savings balances will grow, as people exit the stock market and move their money into safer, insured deposits. So the liquidity crunch, the margin squeeze, and the interest rate risk will be resolved, albeit painfully for the broader economy.
All of this is likely to happen relatively soon, as I'll address in the next post. For now, let me make two final points.
First, many people might say, "Yes, only three banks have failed this year, but their combined assets are more than the total assets of banks that failed in 2008!" And why wouldn't they say that? The media is shouting it from the rooftops: "Recent bank failures eclipse 2008 levels!" (Never forget that the media sells hype, and that business journalists are, by and large, morons.)
As I noted in the post linked above, we need to consider asset growth since 2008. Yes, SVB, Signature Bank and First Republic, when seized, had combined total assets of over $548 billion. And yes, that's more than the $374 billion in assets of the 25 banks that failed in 2008. However, to compare apples to apples, we have to look at how large the three banks that have failed this year were in 2008. The answer: less than a combined $47 billion in assets. That's only about 12.5% of the magnitude of the bank failures in 2008. Not one of those three banks was as large in 2008 as the two largest banks that failed that year - not even close.
My final point is this: if you believe that social media hasn't played a role in this year's bank failures, you're a Pollyanna. With the advent of meme stocks and APE investors (you know, those people who think that companies like GameStop and AMC are great stock buys, and actually think they understand the financial markets), there are a lot of people slinging around opinions on Facebook as if they knew what they were talking about.
Simply put, they don't.
Some of them are my friends, and I just have to shake my head and chuckle at how ill-informed, and just plain wrong, they are when they opine about all things financial. (I'll address another such fallacy in my next post.) That stuff spreads like wildfire, and their equally ill-informed friends gobble it up, because, "Gee, Jim's a smart guy, he must know what he's talking about, he works for a bank, after all." (Never mind that Jim works in HR or IT, and doesn't really understand how interest rates move, or how markets work.) So the friends share those posts with their friends, who ... you know how it works.
Twitter, in fact, is known to have led to the run on deposits at Signature Bank. Not that Signature didn't deserve to fail, but the deposit run wouldn't have happened without social media.
Here's all the proof you need that social media has played a role in spreading fear over an imminent banking crisis, and leading to unnecessary deposit withdrawals that threaten to turn those dire - if wrong - warnings into self-fulfilling prophecies:
The only place I've seen the claim that social media didn't contribute to any of these bank failures, is on social media. Let that sink in.
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