We start this week's post with a comment on the Federal Reserve’s annual bank stress test results, released June 28^th—not because they held any real surprises but because they clear the deck for the next act during which the banks, the regulators, and perhaps Congress, will arm wrestle over changes to capital requirements and bank supervision.  This could lead to a major alteration in the bank landscape for depositors and investors. There is also the July 1 rollout of FedNow, the new 24/7 payment system. And finally, a bow to money market yields, now largely north of 5%.

Have a great weekend!

Federal Reserve Stress Test Results—No Surprise

June 29, 2023

The results of the annual stress test were released June 28 and...

Surprise, surprise, in the words of Vice Chair for supervision Michael S. Barr, the results “confirm that the banking system remains strong and resilient.”   The test results found that 23 large banks are well positioned to weather a severe recession (a rise in the unemployment rate to 10%, a 40% decline in commercial real estate prices, and a 38% decline in house prices) and continue to lend to support the economy.

Keep in mind that the stress tests were applied to only 23 of the largest US banks. And they did not report on the effect that sharply rising interest rates could have on the banks.

What does it mean? Take them for what they are:  capital adequacy tests applied to the largest banks to test the effect of a severe economic downtown. For public funds investors that are depositors in these large banks and those who invest in their bonds, commercial paper and negotiable certificates of deposit, the test results should be reassuring.

The test results do not, however, speak to the rest of the country’s nearly 10,000 deposit-taking institutions.  Three of these institutions failed earlier this year, roiling markets for a few days and costing the FDIC billions of dollars to make depositors whole. It’s fair to say that the stress tests are an assurance that the “too big to fail” banks should not require a bail-out during a severe recession. But beyond this the results add little.

Bank Capital Requirements and Supervision Could Change the Landscape for Investors

June 29, 2023

Next up, Federal bank regulators, led by the Federal Reserve, will turn to rolling out new capital requirements and revised supervisory procedures—in part as a response to the above-mentioned bank failures and in part to implement the Basel III Endgame.

Enhanced capital requirements will implement the final round of changes proposed by the 45-member Basel Committee on Banking Supervision in response to the Great Recession of 2008. The overall objective of the Basel accord is to modernize and harmonize bank regulations across nations. For If you want to know more about the Endgame see the very readable PWC analysis.  

Along with revised capital requirements will come rules for enhanced supervision in response to the failure of Silicon Valley Bank and two others. The Fed’s self-examination of the failure of Silicon Valley Bank, led by the Vice Chair for supervision Michael S. Barr, set the stage but the all-important details will take some time to be revealed.

Enhanced capital requirements will cost money—lots of money—and the banking industry argues fiercely that this is unnecessary or, at a minimum, that the requirements should be tailored to limit their application and effect.

The back-and-forth among the banks, regulators, and interested members of Congress will play out over the coming months. For example, Fed Chair Jerome Powell stated in recent Congressional testimony that smaller banks would likely be exempt from higher capital requirements.

As to supervision, some members of Congress have said that the need is for better application of current rules rather than adding new ones.

But, but. . . It’s not in the headlines but don’t lose sight of the potential for these changes to lead to significant consolidation in the banking industry that could change the bank landscape for public funds investors. 

 Fed Governor Michelle W. Bowman, who represents  community banks on the central bank’s board, warned in a recent speech that  revising regulatory standards could “create intense pressure on the smaller end of that spectrum to consolidate.” For context, there are currently around 10,000 deposit-taking institutions in the US. By contrast Canada has about 85, France, about 400, Japan, about 125 and Germany less than 1,500. 

Consolidation could aid large public funds investors and LGIPs but disadvantage smaller government investors. Here’s how:  For those who invest in commercial paper, negotiable certificates of deposit and corporate bonds the supply of these securities could expand if significant consolidation created more large banks, since large banks generally access the public debt markets to fund their activities. The volume of rated money market securities could also increase because larger banks generally have credit ratings, and these banks would make more comprehensive disclosure of their business and financial conditions.   So better investment opportunities and more transparency might be a result. Large, sophisticated public funds investors and their advisors have the resources to take advantage of these changes.

But smaller community banks provide opportunities for the public sector that are often not available from the mega-banks. They are the source of deposit accounts that are responsive to local needs and support smaller communities. Think wholesale vs. retail. These opportunities could diminish if consolidation occurs.

None of this will happen overnight but the long-term implications could be significant.

Happy July; It’s FedNow Time

June 30, 2023

FedNow, the Federal Reserve’s new instant payment service that provides financial institutions with the ability to offer 24/7 payments that settle nearly instantly at a cost of a few cents, is set to launch in July. With that, the United States will join nearly 80 other countries that have the infrastructure to provide for widespread instant payments. There has not been a great deal of publicity about FedNow but the Fed has created an interesting website with lots of detail.

Don’t expect to see FedNow change the current payment system in the short run.  This is so because:

•  FedNow will not be available directly to consumers; rather it will be accessed through financial institutions that have aa account at the Fed. The Fed has initially certified 57 organizations for the roll-out. This is a small fraction of the country’s 10,000 deposit-taking institutions.
• FedNow transactions will initially be limited to $500,000, so large money movements will continue use the Fedwire and ACH.
• Third party transfers will not be accommodated.

Over the long term FedNow likely will result in changes to the way investment officers have to manage liquidity.

For example:

•  If payments can be made 24/7 how will cash be managed/funded?
• How will receipts via FedNow be invested intra-day and over weekends?
• Banks may offer short-term investment products to sweep cash, but if they rely on deposit accounts how will these be secured if balances change outside of normal business hours?
• Banks may offer to fund payments via daylight (or weekend) loans, but are public agencies authorized to make such borrowings?

Local government investment pools that offer cash management/payment services will have to consider similar issues on a larger scale to manage cash outside of normal hours and to interact with financial intermediaries who will be required to honor instant payments (and receipts) when they occur.

If you are an early, early adopter, you might reach out to one of the 57 organizations  that gained initial certification.

Briefly Noted: Money Market Yields Firmly Above 5%

June 30, 2023

Stable value LGIP and money market fund yields have now largely moved above 5%.

These are the highest yields in more than 20 years. Good news for investors!