In early May, the second largest bank failure in the history of the United States occurred as First Republic Bank was assumed by JP Morgan Chase, making this the 3rd bank to fail in 2023.
This collapse was due to a shrinking deposit base in what many are calling a digital bank run. However, this process has been in the works for quite some time, moving in slow motion since the Federal Reserve began its hiking cycle in April of 2022, in what some economists have dubbed as a “Bank Walk” instead of a bank run.
How It Started
Banks are (mostly) like any other business in that they operate in markets and need to make a profit to stay in business. Retailers buy goods (beer, computers, cars) from wholesalers and sell them to consumers, with the spread between what they bought them for (wholesale price) and what they sold them for (retail price) largely determining their profit.
Banks buy and sell money (loans), and their profit is the net interest margin on those loans, which is the difference between the cost of the money (deposits) and what they can sell them for (loans).
Banks take in money through deposits from their customers and pay their customers’ interest on those deposits. These can be savings and checking accounts (demand deposits) or certificates of deposit (time deposits).
Banks can lend risk-free to other banks at the Federal Funds rate, which also acts as a floor for the interest rates they charge on other types of loans (consumer, commercial, real estate, etc.).
Initially, as the Federal Reserve raised the federal funds rate, the interest banks could earn on those deposits increased tremendously, while their cost of capital (demand deposits and timed deposits) has not risen to the same extent.
How It’s Going
As the spread between what consumers could get at their bank (timed deposits) and what they could get in a money market account or short-term treasuries increased, people have opted to withdraw their money from low-yielding bank accounts into other higher-yielding alternatives.
A flood of money poured into banks due to government stimulus measures at the start of the pandemic, and banks needed to issue a correspondingly large amount of loans during that time to balance their assets (loans) with liabilities (deposits). Since federal funds rates increased in mid-2022, there has been an increase in bank deposits seeking higher yields.
As the spread between what consumers could get at their bank (timed deposits) and what they could get in a money market account or short-term treasuries increased, people have opted to withdraw their money from low-yielding bank accounts into other higher-yielding alternatives.
A flood of money poured into banks due to government stimulus measures at the start of the pandemic, and banks needed to issue a correspondingly large amount of loans during that time to balance their assets (loans) with liabilities (deposits). Since federal funds rates increased in mid-2022, there has been an increase in bank deposits seeking higher yields.
Deposit outflows are accelerating and have been slowly increasing for the past 18 months. While not a bank run (consumers afraid of bank collapse), we may soon be approaching a bank powerwalk consumers frustrated at their banks’ low rates), or if the Fed continues to raise rates and the deposit gap continues to rise, we may enter into a bank light-jog (regional banks enter into an arms race to attract deposits which grow their negative net interest margin and increases their likelihood of failure).
Conclusion
The entire bank regulatory system is based on the assumption that bank deposits are sticky, i.e., people do not shop around for the best rate, and the money in the financial system sloshes around safely and predictably. This was true in the era of in-person banking, with bond rates at zero or even negative levels. As the price of money has risen (interest rates), consumers can move money around digitally with near zero friction between financial institutions. Money is flowing to money market funds and treasury bills, as these offer better yields for cash. The recent bank runs we have seen this year (SVB, Signature Bank, First Republic) started as a bank walk as consumers moved their money towards higher-yielding options, which decreased the net-interest-margin the banks could charge, leading them to sell assets at a loss to meet these withdrawal requests.
The Federal Reserve system has two mandates, stable inflation, and maximum employment, but an unspoken bonus mandate is the need to protect the banking system, as that is the tool upon which the Fed can impact the first two mandates. Mobile banking has disrupted the banking sector greatly, allowing money to move much freer than before. These are especially tumultuous times due to the buildup in bank deposits due to fiscal stimulus measures during the pandemic. The unwinding of these measures will ensure further sloshing of money around the financial system, bank-walking if you will.
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