Pub. 11 2023 Issue 3

Banking Trouble With Liquidity

Throughout history, intrepid men have ventured around the globe and occasionally stared into the abyss, and the abyss has stared back. Sometimes, it was nothing more than a frightening experience, but for others, it ended in disaster or near disaster. Right now, I believe, bankers are staring into the abyss and wondering either quietly or possibly loudly, if we are going to succumb to the abyss or if disaster will be averted.

We are at a perilous point in our banking journey as we experience the most severe and rapid interest rate increases the country has seen in well over 35 years. The consequences are not fully known, but preliminary findings are shocking. Of Montana’s 37 banks, 29 saw deposit contraction in the first quarter of 2023. In fact, Montana annualized average deposit growth in Q1 2023 was negative 13.1%. This is not insignificant.

Banks that were swimming in deposits during the pandemic are now experiencing a liquidity crunch impossible to predict two years ago. What is driving this exodus? While it is a complex problem with many possible factors, I believe there are two primary causes behind the rapid depletion of liquidity.

First and likely the lesser of the two factors is a “flight to safety.” When the FDIC decided to make the depositors of two recently failed banks whole, they sent a signal to customers that the bigger banks were safer because the FDIC would not let these large banks’ depositors lose money. While it is understood the FDIC took this position to prevent contagion, it reinforced the idea of “too big to fail.” The result is that depositors believe their uninsured deposits are inherently safer in bigger banks because the FDIC will cover them regardless of policy limits. This negatively impacted small- and medium-sized community banks as their customers sought the perceived safety of the larger banks. How much deposit runoff is attributable to this factor is unknown and difficult to quantify. It was an undoubtedly difficult decision to make at the highest levels of the FDIC and may have been the correct decision, but the unintended consequence is the creation of a perception that the FDIC will always look after big banks and thus, your money is safer there. Again, difficult to quantify, but impossible to ignore.

The second, and likely most impactful, reason behind the tremendous deposit runoff is the rapid interest rate increases instituted by the Federal Reserve Bank to slow inflation that recently hit a 40-year high. The theory was that the increased cost of credit would cool the economy and bring inflation back down to the desired level of 2%. The unintended outcome is that consumers are fleeing traditional banks for alternative products such as institutional CDs and U.S. Treasuries. And who can blame them? It is not unheard of in today’s market to invest in vehicles generating 5% or more on fully liquid accounts. Banks have increased deposit rates, but not steeply or rapidly enough to slow the bleeding. Many banks have been caught by surprise when their customers abandoned ship so quickly. With interest rates extremely high compared to the last 15 years, borrowing has slowed, and banks cannot add enough higher-yielding credits to fully offset the now much higher cost of funds. The result is net interest margins are taking a hit, and, if they haven’t yet, they are about to soon. Many banks have been forced to either borrow Fed Funds or utilize the Federal Reserve’s Bank Term Funding Program, neither of which are attractive alternatives. Compared to recent funding costs, these funding sources are exceptionally expensive and depending on each bank’s balance sheet and deposit losses, are going to wreak havoc on the Net Interest Margins across the land. Banks have become liability sensitive practically overnight. And, we haven’t even mentioned the disappearance of non-interest income related to declining mortgage originations. To say it is a challenging time for banks would be an understatement.

While it is understood that high inflation is bad for the country, the side effects of rapid interest rate increases on community banks cannot be ignored by the Federal Reserve. If they keep pushing interest rates higher as is expected, it will exacerbate the situation and community banks will suffer mightily. Additionally, there could be a potential impact on the FDIC’s deposit insurance fund balance which is already below target levels.

There is no easy answer to the current situation and never mind the policies that caused the problems in the first place. Community banks cannot be sacrificed in the name of inflation reduction when they had nothing to do with causing the problem and are truly essential to local economies. Historically, the Fed has overcorrected in times like these and now would be a good time to hit the brakes before the situation becomes more damaging than it already is. Community banks are the economic backbone of many Montana and rural communities across the country. Our challenges cannot and should not be ignored in the name of a metric whose achievement could cause more harm than good across our industry. After years of serving our communities, we deserve better.