Reporting by Greg Debski, CFA
Leverage can sting, cash flow can maim, but liquidity kills…
Industry-wide risk events typically have a common cause, and the current volatility in the banking sector seems to stem from the combination of two identifiable sources. The first and broader-spanning source of volatility in this case is the fallout from the rapid rise in interest rates throughout the past year. Banks, at their core, are “spread” or interest rate “matching” entities. They pay an interest rate to depositors to “use money” which they then invest or loan out to creditors to receive interest payments. For reference, think of the interest you receive from a savings account versus the interest you pay on a mortgage or car loan. Simply put, the difference between the rate a bank pays for deposits and the rate a bank receives from loans is how they make money. Customer deposits are extremely liquid and short-term in nature—you can go to your bank and pull your cash out pretty readily when you make up your mind to do so. However, the loans made by banks to earn revenue are typically illiquid and longer-term in nature, spanning years or even decades. Interest rates have a direct, inverse relation to the value of assets on banking balance sheets, meaning that as interest rates go up, the value of the assets (i.e., bank loans) go DOWN! As you can imagine, if you’re a bank and your depositors panic because of a drop in the value of assets on your balance sheet, you could have a pretty big problem. Depositors fleeing a bank in excess of the bank’s ability to raise liquidity is commonly known as a “bank run” and is not a new phenomenon—see the 1946 Christmas classic “It’s A Wonderful Life” for some cinematic representation.
We continue to believe that this is not a repeat of 2008, for some simple but very important reasons. In 2008, banks extended too many risky real estate loans and held tenuous derivatives when housing prices collapsed. Large portions of the banking industry took immeasurable amounts of levered risk (they got cute…) and got punished for it. This time, a historically rapid interest rate shift is testing all banks’ ability to do their core jobs properly, and catching the poor operators “asleep at the wheel.” The most encouraging point is that the vast majority of the industry is doing its job correctly, and passing a rather rigorous risk test without much fanfare.
Every adversity is an opportunity for education, so what can we learn from this particular crisis? For starters, with banks back in focus, it’s a good reminder that FDIC insurance for deposits is $250,000 per depositor per qualified bank2. Additionally, only checking accounts, savings accounts, money market deposit accounts, and certificates of deposit are covered. Maintaining balances exceeding insured deposits may not be the most prudent move. Additionally, not all banks are created equal, and size does not necessarily equate to quality. At Naples Global Advisors we are always happy to provide objective feedback on the fundamental quality of a bank you may be considering for your banking needs; please just ask.
Especially during times of uncertainty, the greatest source of confidence and reassurance is often as simple as having a clear, actionable path forward. Our typical client meeting discussions cover a broad range of topics, and usually include personal liquidity management along with asset diversification, precisely for times like this. If you would find such a “big picture” discussion valuable, please call us so we can schedule a time to get together. The goal of all discussions is essentially the same; to provide guidance onto and along the path with the highest probability of long-term financial success. We’re always here to help, but especially when our collective path hits a few bumps!