This is what traditional banks have been doing for hundreds of years: They collect deposits from mom-and-pop types of customers who normally use only one bank for all their financial needs. These funds are mostly CASA (Current Account, Savings Account) deposits and are relatively sticky, meaning that they do not leave the bank very easily and are normally dormant too.
Banks take advantage of this CASA by paying little or no interest. It is like a free loan to them! Just check your current/cheque accounts now. You are probably still getting zero interest even after the Fed’s aggressive rate hikes last year.
What do traditional banks do with all these “loyal” and sticky deposits then? They place them out to work to earn a higher yield to boost their profits. A measure of how well and profitable a bank is utilizing its duns is called NIM – Net Interest Margin, to measure the difference between a bank’s average cost of funds versus what it can earn. You will hear “borrow short term, lend long term” regularly in banking circles as a means of a bank’s funds management strategy. Banks seek to lend long-term to corporate and retail clients (eg. credit facilities, building/housing loans) while utilizing/borrowing short-term CASA funds or through the interbank overnight (O/N) markets.
In normal times, the interest rate curve is upwards sloping, meaning that short-tenor rates are lower than long-tenor ones. Banks will effectively “ride” the yield curve by placing out money long-term to earn higher rates and borrowing short. Yield curves may occasionally invert for countries in distress where short-term borrowing costs shoot up much higher as lenders demand a higher risk premium.
To effectively manage the various risks associated with the above-mentioned process, banks traditionally set up ALCO (Asset and Liabilities Committee) groups consisting of the CEO and senior members of the team like the Treasury head and the CFO. The ALCO normally have monthly meetings to review the bank’s portfolio to review various parameters like interest rates, foreign exchange, gapping and counterparty risks. Financial benchmark triggers are also put in place to be monitored and reported in a pre-meeting ALCO deck for members to review. The intention is to spot red flags in advance, prepare for possible black swan events and avoid them via proactive contingency planning.
Funds are also carefully bucketed and monitored by tenor, instrument and counterparty to avoid high-concentration risks on a particular area or tenor. Limits are usually set for each as benchmark trigger points for early warnings and red flags. This dynamic juggling of multiple balls in the air within an ALCO framework helps a bank avoid preventable disasters proactively.
There is a regulatory reserve ratio requirement that regulators set, requiring banks to keep funds in reserve and not to be lent out. To also prepare for a possible run on the bank due to unforeseen circumstances, banks also do create a cash buffer of sorts to backstop these situations. This conservative buffer of X number of months of cash flow needed is kept as cash in the bank at all times in preparation for a sudden run on the bank. Counterparty risks are also monitored religiously to ensure that it is not too heavily exposed to a few opposite counterparties in case one of them fails.
The recent bank failures have brought into question the viability of banks as an effective risk-mitigating mechanism to effectively provide funds management in the global banking system. SVB, Signature Bank, First Republic, Silvergate and Credit Suisse have exposed glaring flaws of the taken-for-granted banking processes which had worked so well before.
See my previous article below for a more detailed writeup on the recent bank failures: https://medium.com/@checkwoei/svbed-a-chaotic-week-and-more-to-come-d33311b74e12
There are preventable internal failed processes which can be identified. SVB’s ALCO was caught sleeping at the wheel during one of the most aggressive rate hike cycles in 2022. Gapping and counterparty risks were ignored. A comedy of errors coupled with a bank run forced regulators to seize the bank to avoid a full-blown banking contagion crisis. By the way, SVB didn’t even have a functioning Chief Risk Officer for most of 2022!
Is the concept of sticky CASA no more? In the current age of online banking and mobile usage, the transfer of funds takes seconds. There is no need to queue up at the bank branch to start a bank run anymore. Most people nowadays bank with more than one bank. Digital neo-banks make the adoption of a new bank account even easier. A serious bank run can now be staged in less than 24 hours with the help of social media. A bank may not be able to react fast enough to a tsunami of funds outflow to save itself from insolvency.
Perhaps in the near future, because of the speed and mobility of money thanks to technology, banks would have to institute lock-in periods for depositors like mutual funds. For example, allowing only 25% of a client’s money to be withdrawn immediately, 25% within a week and the balance a month later. This will provide some time buffer for banks to react and execute their emergency contingency liquidity plans more effectively.
A positively sloping interest rate yield curve is usually the case in a regular market environment. When the curve inverts, it is a warning red flag sign that should be taken seriously to readjust the portfolio for banks. The unusual 2022 aggressive rate hikes inverted the yield curve for months. Many banks had structured their portfolio to borrow short and lend long-term to ride the yield curve. This basic standard operating procedure is now in question.
Gapping issue – the time difference between your assets and liabilities. Bank depositors’ requirements to withdraw (liabilities) versus your assets parked in US Treasuries with maturities in a few years. Too much money rushing out the door while they are parked in longer-tenor assets resulted in a mismatch that became the ultimate stroke that broke the camel’s back for SVB.
A study estimates that all banks currently have about $650 Billion of unrealised mark-to-market (MTM) losses. This is a similar situation to what SVB had on their books due to its gapping/timing issue. These unrealised losses can now be “hidden” if they are placed in HTM (Hold Till Maturity) books where MTM is not required to hit their bottom line immediately. Should this accounting loophole be tightened for the sake of transparency? Maybe banks should set aside a fraction of the total MTM loss of their HTM books (eg 25% instead of zero currently).
Less discussed was another reason why the American banks failed. It was a few years in the making. The Dodd-Frank Act was enacted in 2010 because of the 2008 GFC. It required banks with assets of $50 Billion or more to submit regular stress test results to the regulators periodically. In 2018, the act was “successfully” changed after fierce bank lobbying to raise the threshold from $50 to $250 Billion.
Guess where SVB, Signature and First Republic were in asset size? They all had assets below the new threshold and were able to hide below the radar of regulators. Internal/ALCO management failure coupled with no requirement for external regulatory monitoring via stress testing resulted in shit hitting the fan a few years later. The 2018 changes to Dodd-Frank should be revoked to bring the threshold back to the original level of $50 Billion immediately to prevent mid-tier banks from having the same fate as SVB.
Fundamentally, banks need to re-evaluate the recent close-shave banking crisis and ask themselves if the old way of doing business has stopped working. The yield curve inversion may last much longer in anticipation of a coming recession and this will stress the portfolios even longer. Regulators have learned from the 2008 GFC to react and move swiftly this time to prevent contagion and avoid the domino effect.
Banking is about the confidence game. The speed of transactions has now moved into the nanoseconds of real-time transactions while banks are still using old and “tested” ways of monitoring risk every month. The reaction timing mismatch is glaring. Perhaps it is time now to fundamentally relook at how banking should be run in this new age digital world.
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