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Hidden to Market

This is a syndicated repost published with the permission of Fed Guy. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

There is little risk of a crisis in the banking sector, but that does not mean there aren’t badly run banks. QE and Basel III have made the banking sector significantly more liquid and resilient such that a replay of the GFC is very unlikely. However, individual banks under poor management can still be subject to bank runs. At a high level, a bank has short-dated liabilities and longer dated assets. A well managed bank holds enough assets to meet potential outflows, but also manages its liabilities to avoid substantial outflows. This post reviews the basic liquidity problem banks face, shows that SVB was particularly poorly run, and suggests that higher rates and QT will challenge bank liquidity in the coming years.


Basel III and QE have made the banking sector liquidity much higher since GFC

Asset Values

Banks don’t have to mark all their assets to market, but unrealized losses have a direct impact on their available liquidity. All assets on a bank’s balance sheet fluctuate in value over time depending on factors like interest rates and market conditions. Suppose a bank bought $100 in Treasuries that then traded at $90 as interest rates rose. The bank has a $10 unrealized loss, but if they held the Treasury to maturity the value would recover to $100. These fluctuations affect both loans and securities and can be managed through derivatives. A bank’s unrealized losses are opaque because of accounting choices and valuation difficulties. But usually those losses don’t matter, unless you really need to raise cash.

SVB had much larger unrealized losses on its securities than peer banks

Banks have a wide range of options to raise cash, but all those options depend on the market value of a bank’s assets. A bank could sell an assets outright at market value, or borrow against it. There is a range of lenders that are willing to lend secured to a bank, ranging from private investors to Federal Home Loan Banks to the Fed’s discount window. But they will only lend against the asset’s market value (plus a hair cut). A significant amount of unrealized losses means that a bank has less potential cash to meet withdraws. An exception is the Fed’s new facility, which is willing to lend against the face value of Treasuries and Agencies. Note that medium and small banks usually hold very few Treasuries and Agencies.

Liability Management

Deposit liabilities are difficult to value because they can in theory be withdrawn at any time, but are in practice “sticky.” The account balance of a typical depositor fluctuates, but they usually keep a certain sum in the bank. Rather than an overnight loan, a deposit is more like a long dated zero coupon bond. The value of deposits are not marked to market, but in theory they become less valuable with higher interest rates. Higher rates can reduce the value of a bank’s assets, but they can also reduce the value of their liabilities. A bank that manages its liabilities well will not need to fire sell its assets to meet withdraws.

SVB had much more volatile liability structure than peer banks

Banks have a number of tools to manage their liabilities. A bank can structure its liabilities by issuing CDs or other contractual borrowings that are not due until a set maturity. It can also diversify its depositor base across account types, as some depositors are more volatile than others. For example, retail depositors are protected by $250k in FDIC insurance so they tend to be very sticky. But large depositors are not fully covered and may withdraw their money suddenly in fear of losses. A bank whose deposit base is almost entirely uninsured is very vulnerable to bank runs.

Higher Rates Decrease Liquidity

The level of liquidity in the banking system is exceptionally high, but is set to steadily decline from higher rates and QT. Higher interest rates reduce the market value of bank assets, which reduces the amount of cash that a bank can raise. A secular upward swing in interest rates can potentially impose huge losses on both the securities and loan portfolio of banks. At the same time, QT is set to steadily withdraw a over a trillion in liquidity out of the banking system over the next two years. This is not a problem today, but it may be in the coming years.

Banks have significant unrealized losses on their securities portfolio. Note that some of these holdings will be hedged.

The post Hidden to Market appeared first on Fed Guy.

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