The flight to money funds increases the burden on small banks

(Bloomberg) – Banks are in an impossible position after the most turbulent month since the 2008 financial crisis.

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Keeping interest rates on deposits near zero is becoming increasingly unsustainable as the collapse of Silicon Valley Bank, Signature Bank and Silvergate Capital Corp. put savers on high alert to seek better and safer alternatives. But raising interest rates enough to compete with money market funds is also a non-starter that would squeeze profit margins and potentially roil stock prices.

It’s forcing a rethink about the traditional role lenders have played in the US financial system and economy – and whether there are simply too many of them.

The turmoil has shown that there are other places people and businesses can park their excess money and get a better interest rate. What has been a slow flight from low-yielding savings accounts over the past three weeks has turned into a turbocharged sprint to higher-earning alternatives. And smaller banks are feeling the pain far more than their larger peers. Deposits at such lenders collapsed $120 billion in the week ended March 15, while those of the 25 largest companies rose nearly $67 billion, Federal Reserve data showed.

For more than a decade, banks have been able to pay depositors rock-bottom interest rates. When the Fed cut interest rates during the financial crisis, it ushered in an era of low interest rates that allowed banks to borrow cheaply and make handsome profits on lending.

Now the ground is shifting. The Fed was quick to raise its borrowing benchmark over the past year in a bid to curb inflation – but banks have been slow to increase the rates they offer their customers, fearing what it would mean for their margins.

“The bottom line is that deposits were taken for granted for a very, very long time due to the zero interest rate environment, and now that has completely changed,” said Joseph Plevelich, senior research analyst at Pekin Hardy Strauss Wealth Management.

Read more: SVB collapse shows the world’s favorite safe-haven asset is not risk-free

Even before the rapid-fire bank collapse, lenders were facing strains created by the Fed’s aggressive rate hikes. Lower-yielding investments and loans reduce bank profitability, even as it becomes more expensive to borrow money to finance further lending.

Money market funds, on the other hand, have been much more adept at passing on the Fed’s rate hikes. They are now piling up a record $5.2 trillion, and some predict the flow from banks to funds may continue.

Money funds park cash in short-term instruments such as Treasury bills or repurchase agreements and pass their earnings on to investors. Although immediate concerns about more bank failures have receded, investors continue to pump cash into mutual funds, pumping about $66 billion into US mutual funds in the week ended March 29, according to the Investment Company Institute.

Less lending

The shift from bank accounts to money funds and other instruments is likely to put more money in the pockets of troubled savers, but there is concern that a shortage of deposits will leave the US with a smaller number of community and regional banks and less money to lend – and that in turn could slow growth and exacerbate inequality.

Many banks make little attempt to compete with money market funds to lure customers back. They are either unwilling or unable to raise deposit rates as they are still suffering losses on investments made in lower-yielding assets before the Fed started raising rates. Some banks reeling with higher interest rates have collapsed: Signature and SVB offered the highest deposit rates in the industry. Read more: Why US banks are converting deposits into money funds

Even the smallest banks in the country play an important role in the economy. From a report by the Federal Deposit Insurance Corp. from 2020 shows that community banks – institutions with assets of 10 billion

Bank loans are an important source of financing for small businesses, which employ about 46% of Americans working in the private sector and have created nearly two-thirds of the jobs created since 1995, according to the US Small Business Administration.

The prospect of widening wealth inequality — a trend the Fed was keen to reverse as part of its 2020 framework change — is front and center for economists like Krishnamurthy Subramanian, Executive Director of the International Monetary Fund.

Community and regional banks are major lenders to individuals and small businesses, a far cry from the largest and wealthiest US cities.

“The people who bank with them, who aren’t as wealthy,” will be hit hardest by the struggles of smaller banks, said Subramanian, a former chief economic adviser to the Indian government. “Big banks will not be affected this time.”

closing the gap

For the time being, the consequences of the evacuation from the deposits have been contained. The Fed, along with the Federal Home Loan Banks, has filled much of the funding gap. And the FDIC’s decision to insure previously uninsured deposits with SVB and Signature Bank has helped allay some savers’ concerns about bank safety.

However, some industry observers say these moves are only a limited buy of time and the flow of cash from lenders is likely to continue.

“Until regulators or the government actually say all deposits are insured, the implied assurance doesn’t really count,” said Joseph Mevorah, senior managing director at Empire Valuation Consultants. “Over the next few months, you’re going to see a steady decline in these banks.”

Mevorah began his career liquidating failed or failed savings businesses during the Savings and Credit Crisis, a financial panic triggered by aggressive interest rate hikes that led to a government bailout of the industry and an overhaul of banking regulation.

A steady reduction in deposits is not the only challenge for banks.

Since the Fed’s fight against inflation began, banks have watched the value of their sizable bond holdings fall as debt bought at lower interest rates is worth less when interest rates rise. The same is true of mortgages and other loans that banks provided when customers desperate to secure low interest rates decided to borrow.

While accounting flaws have protected banks from the worst impact of these unrealized losses, banks still face significant stresses that could erode profits in the short term and cause more damage later.

Margin Squeeze

Even before the recent crisis, it was clear that some banks were losing deposits, pushing them to rely more heavily on alternative funding sources such as the FHLB scheme.

Some also responded by raising the interest rates they offered on deposits to lure savers back, but even so, average interest rates remained well below what mutual funds and other trading venues could offer.

Raising interest rates on savings accounts and certificates of deposit can attract cash, but it will also likely depress banks’ net interest margin, or NIM, a key measure of their financial health that compares how much they make on interest-bearing assets against what they call interest-bearing loans Pay liabilities like deposits.

“These earnings numbers are going to look a lot worse,” said Nathan Stovall, an analyst at S&P Global. He said that could lead to consolidation if it pushes bank executives already considering selling past the tipping point.

“Perhaps you would have been willing to accept some margin compression. They might have been willing to take a 5% drop in income,” Stovall said. “But are you willing to accept 10 or 15? I think that might drive people over the edge.”

–Assisted by Brian Chappatta, Dan Wilchins and Blake Schmidt.

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