Last week Moody’s took ratings action on 27 US banks. This week (so far) the chairman of the Federal Deposit Insurance Corporation announced that his agency would issue regulations requiring that large regional banks (assets greater than $100 billion) adopt “living wills” to facilitate resolution in the event they become insolvent. And FitchRatings warned that it could downgrade dozens of US banks. Oh, and in the background, there is the overhang of proposed new capital requirements to implement the Basel III regime. (See Beyond the News July 28, 2023.)*
The big picture: What’s going on
Banks are in the headlines for three reasons:
How significant? One measure of this is the below chart that shows the ratio of bank deposits to GDP which has grown over the last generation as the US economy has changed in character. (Though detailed data since 2020 is not yet available the trend is thought to continue.)
What this means for public funds investors
The headlines should not be cause for alarm but should trigger a thoughtful risk management focus. Particularly since public funds portfolios are managed in the fishbowl of public—and political—opinion and the scrutiny can raise questions that corporate treasurers usually do not face.
Risk management should start by considering the nature of the bank services and the size of the bank.
Treasury and cash management customers of a bank are exposed to different (lower?) risks than deposit or investment customers. To state what should be obvious, when you stop by a bank ATM to get cash you don’t consider whether the bank is credit worthy, but whether the ATM is operating. Once you’ve gotten your cash (and your card back) you can be on your way. One might generalize this as going concern risk related to bank cash management/treasury services. But if you deposit your retirement account (or your payroll account) in the bank you’d better be confident that you will be able to draw the assets in full when you need them. So, you want to determine the bank's credit risk.
Bank business services and deposit/investment offerings may be tied together—banks are not shy about upselling—but one should be more careful when they are.
Analyzing a bank’s credit worthiness is complex, and sophisticated institutional investors have teams of specialists who do this. Deposit insurance, which can be multiplied by using deposit insurance registry services like CDARS, can provide security. Public sector investors may have options like deposit collateralization that are not available to the private sector, but not all collateral regimes are strong, so one should not take them for granted. And keep in mind that deposits may be secured by collateral (including letters of credit issued by the Federal Home Loan Bank) but generally other bank obligations are not. If you own commercial paper or bank bonds you’re on your own, as they say.
Large banks, particularly the global systemically important banks, are probably too big to fail. Federal regulators are quick to deny this, but reality suggests otherwise. Depositors/investors in large banks also are part of the public market ecosystem with publicly traded stock and debt and the banks are scrutinized by scores of market and credit analysts, although keeping track of and understanding the analysis is itself challenging. Small banks fly under the radar--there is less transparency. One perverse result of this is that smaller banks might be less susceptible to deposit volatility (aka a bank run) simply because they are out of the public’s eye.
Where is this heading?
In the short run we’re likely to see some further downward adjustment in the credit ratings of the larger regional banks. But unless the economy suffers from a credit crisis and/or a sharp recession, the credit fundamentals (the ability of these banks to pay bond investors and depositors) should stabilize within the range of what is generally described as investment grade.
Also in the short run, banks will be working to replace deposits and, as Moody’s concluded in its report last week, they will have to raise deposit rates to do so. According to Moody’s the median deposit rate in the second quarter of 2023 for 16 of the largest banks was 5.94%, up by nearly 1% from the fourth quarter of 2022. Deposit rates could rise further this quarter, even without further Federal Reserve tightening.
In the intermediate term, expect banks to try to raise the price of treasury/cash management services to offset some of the loss of margin between their borrowing and lending rates.
Longer-term, it’s complicated. The banking industry is likely to evolve with the merger/consolidation of many smaller banks and enhanced capital requirements for larger banks. Community bankers warn that this could restrict credit in smaller communities and to small businesses. Competition to offer treasury/cash management services could decline and banks would exert greater pricing power, but through the lens of an investor, larger, better capitalized banks would be a plus.
Swing pricing by any other name is. . .
JP Morgan published a thoughtful analysis of money market reforms last week which observed that the liquidity fee for institutional prime funds required under the Securities and Exchange Commission’s money fund reform rules may not be that different than the complex swing pricing approach contained in the original SEC proposal.
The JP Morgan suggests that the new rules will constrain the competitive characteristics of institutional prime funds and narrow the yield advantage vis a vis government funds. Prime LGIPs are exempt from the SEC’s rules and unless they adopt similar liquidity fees, they should retain a competitive advantage for public funds investors who invest in prime-type funds. This is another data point that LGIP boards and sponsors may consider as they evaluate the implications of the new SEC rules for LGIPs. (See the August 10 Spotlight piece: SEC Money Fund Reforms Raise Important Issues for LGIPs ).
Briefly noted:
CalTRUST has a new investment manager. CalTRUST, a California LGIP, has a new investment manager. State Street Global Advisors replaced BlackRock as of August 1. It’s the first entry of Sate Street into the LGIP industry.
* An earlier version of this post indicated that negotiable certificates of deposit are not subject to insurance. They qualify for deposit insurance to the same extent as other bank deposits.
