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Banks have looked increasingly fragile over the last year.

And besides the three of the four largest U.S. bank failures happening in early 2023, many feel like the worst is over.

But I remain skeptical.

Because - courtesy of the Federal Reserve’s rapid tightening cycle - banks are still sitting on enormous unrealized losses and dealing with compressed profit margins.

To put this into perspective – as of Q3-20231 – banks have over roughly $700 billion in unrealized losses on their investment books.

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Figure 1: Q3-2023

What’s an “unrealized loss”?

·         Simply put – it’s a loss that occurs on paper when the current market value of an asset or investment falls below the price originally paid for the asset, but the asset hasn’t yet been sold.

For example, imagine buying stock and it falls 25%. Technically, you don’t realize that loss until you actually sell it.

And because of this unrealized loss problem, the Fed had to open the discount window (aka where banks can swap assets for reserves at full value with the Fed) and other programs like the Bank Term Funding Program (BTFP).

If they hadn’t, banks would’ve had to likely sell these assets at steep losses on the market – potentially causing a wave of further insolvencies (wiping out bank capital).

So, what now?

Well, I believe the banking system is still fragile, and it’s not likely to get better as long as growth fades and short-term rates remain elevated.

The latest Q4-2023 results from Charles Schwab highlighted this. . .

Via Bloomberg2 - Schwab said net new assets fell 48% to $66.3 billion in the fourth quarter while net income also dropped by almost half. Bank deposits in the period declined 21% to $290 billion and the company’s total retail brokerage accounts fell short of analyst estimates at 34.8 million.

Meanwhile, the U.S. is laying plans3 to “force” banks to use the Fed’s discount window at least once a year now to make it cheaper for banks to borrow from them.

·         Keep in mind that most banks don’t like to use the Fed’s discount window because it implies something may be wrong.

Imagine if everyone knew you needed Mom and Dad to bail you out, it’s not a good look and hurts confidence. And in banking, confidence is everything.

Thus, I believe there are three big factors still negatively affecting banks:

1. Banks tightening lending standards sharply amid growing economic uncertainty and deteriorating fundamentals. Reinforcing the decline in the money supply (which is deflationary).

2. The higher short-term rates have caused deposits to leave banks and rotate into money-market funds (MMFs). Putting pressure on bank stability.

3. Higher short-term rates compared to long-term market rates (aka the inverted yield curve) decrease bank profitability, thus squeezing their net profit margins (NIMs) and causing loan growth to erode.

I believe side-effects from banking issues – such as declining loan creation – are what’s worrying as it historically leads to instability and deflation.

So, let’s take a closer look into all this and why banks may be stuck for a while. . .

Digging Through The Weeds Of Banking And Its Commonly Held Misconceptions

Banking is a wildly complex topic – with many dynamic variables.

Many may downplay the importance of “financial plumbing” – but I believe it is critical in understanding an economy and asset markets.

But I will try to cover what I can and break it down as simply as possible so it’s not dry, but rather compelling.

Before we start, there are a few misconceptions about banking – such as:

1.     Deposits (liabilities for a bank) fund loans (an asset for a bank).

2.     That the central bank ‘prints’ (creates) money into the economy.

3.     That banks lend because of interest rates.

These three things are generally false ideas many have been taught about modern banking.

For instance, the central bank doesn’t print anything. It adds reserves with a few keystrokes (think of reserves as a checking account banks use with each other to clear payments).

·         For example, if Person A at Chase Bank sends, let’s say $10,000, to Person B at Citibank. Then Chase Bank must send the same number of reserves to Citibank.

Why does this matter?

Well for starters, in theory, if the central bank adds more reserves into the system (through programs such as Quantitative Easing – QE), it should allow banks to lend more.

The problem? Well, they don’t have to lend.

This is known as a ‘liquidity trap’ - aka when banks and consumers hoard money instead of lending and spending, regardless of monetary easing.

This is what happened in Japan post-1991, the Eurozone post-2011, and China currently – all saw central banks pushing on a string.

But the truth is, the real money creators are commercial banks.

See – contrary to conventional wisdom – in the modern banking system, bank loans create deposits.

A bank doesn’t check how many deposits it has before making a loan. It simply extends credit. And this becomes buying power for the new borrower.

·         Have you ever heard of anyone going to a bank wanting a loan and hearing the desk employee say, “Ah geez, let me check if we had enough deposits come in today so I can write you a loan.”

To highlight this point, the Bank of England (BoE) wrote an excellent and in-depth whitepaper4 on this topic.

But for those who don’t want to fall asleep reading the BoE’s white paper (I almost did), here’s the gist in a graphic.

The point is that a new loan is an asset for the bank (income generating), but it creates an equal liability (the new deposit on which they owe interest or may leave to another bank or money market fund, etc).

Or - as I like to think about it – the loan is created first and then becomes a deposit.

So, as banks loan more, it increases the money supply (creating deposits as shown in the chart above) via more individuals taking out debt to buy something - which then, in turn, gets deposited into the seller’s bank, and on and on.

This is important because it means that banks are the true money and credit allocators – choosing where they shovel it out to – which are most often in asset-backed areas such as the financial sector, housing, and corporations (as they offer more collateral to back the loan). Thus, fueling asset inflation.

·         Asset-price inflation is the nominal rise in the prices of stocks, bonds, real estate, and other assets. Rising asset prices are potentially misleading signs of a growing economy. Financial assets can be sensitive and volatile and may create an illusion of growth through asset bubbles (remember pre-2008?)

But it’s also important to note the opposite of this - that when debt repayment increases faster than loan creation, the money supply will shrink.

So, what makes banks lend more?

Many were taught that it is interest rates that influence lending. And while it does to an extent, confidence is what drives credit.

Banks extend credit when they feel confident in repayment, liquidity conditions, and financial system health.

·         For example – during 2008 – banks stopped lending to each other and extending marginal credit even with interest rates at zero because of economic uncertainty. Thus, rendering the Fed’s easing programs relatively mute for stimulating the economy.

To highlight this point, look at interbank lending between U.S. commercial banks between 2007 and 2010 - it completely collapsed and remained anemic until 2017, when the Fed “conveniently” stopped publishing this data.

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Figure 3: St. Louis Fed (DISCONTINUED 2017)

I know this may sound counterintuitive and confusing, but this is how modern banking works.

See, for instance, the Fed (or any central bank) can slash interest rates to zero – or even negative. But they can’t control if borrowers will respond to it.

A lower interest rate, in theory, should stimulate borrowing and lending. But doesn’t mean it always happens (as we’ve seen in history).

So, keep these three things in mind for the next part. . .

The Banking System May Still Be On Shaky Ground

As I exhaustively highlighted above, there are many misconceptions about modern banking.

Now that you know about some of them, it’s time to see why this all matters.

Well as mentioned earlier, banks grow liabilities (deposits) and assets (loans) by extending credit.

 Thus, it’s key to study bank lending growth and deposits.

 So, how do they both look? Well, it doesn’t look very great.

 For starters, bank lending has been eroding across the board – from loans and leases (L&Ls) and business loans to revolving credit (credit cards) and auto loans.

Take a look at the year-over-year growth in some commercial bank lending categories as of Dec-2023.

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Figure 4: St. Louis Fed, Q1-2024

The only one that’s trending above pre-pandemic levels is revolving credit amid the surge in credit card debt since 2022. And it’s still declining steadily as of October 2022.

Keep in mind that both loan demand and bank lending standards have eroded – indicating the demand and supply for loans has weakened.

Meanwhile, bank deposits are declining – down -2% year-over-year as of January 3rd, 2024.

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Figure 5: St. Louis Fed, Q1-2024

What makes this more pronounced is that at this time last year, bank deposits were down -1.5% - therefore the rate of decline is actually compounding negative in two-year terms.

The Fed’s tightening and money market funds are likely causing a good amount of this “deposit flight.”

And finally, as I mentioned at the beginning, banks are sitting on nearly $700 billion in unrealized losses.

Oh, and don’t forget that the Fed is pulling money out of the system through its quantitative tightening (QT) program – which further stresses banks as it drains their reserves and thus deposits.

These four things don’t point to a robust banking system. . .

Wrapping It Up

Now, I know this was quite a bit (believe me). But it’s just that important to try and get an idea of banking.

Please note I only just scratched the surface throughout this piece, and plan to write more on banking later.

In the meantime, who knows how things will play out.

Maybe the Fed will cut interest rates in 2024 more than expected to alleviate some of this bank stress.

Until then, I remain skeptical.







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