Executive Summary

This famous line from Gilda Radner’s character, Roseanne Roseannadanna, in Saturday Night Live’s early days, spoke to the reality that there are usually multiple ways that things can go wrong. Several out of work bankers know the feeling.

Imagine that you are a 60-year-old, successful bank executive. Throughout your career, you’ve seen many banks fail. Most were sunk by bad loans: they gave loans to borrowers who could not pay them back. These failed due to ‘Credit Risk’.

Now imagine your bank gets a flood of new deposits as liquidity is injected into the economy during the Covid 19 monetary madness. New deposits are good…this provides opportunity for growth. However, rather than taking undue credit risk in an uncertain economy, you play it safe. Instead of increasing your loan book too rapidly, you buy the highest quality and most liquid assets available: US Treasury Notes. Two years later, you are out of business. What?!?

The “Other” Risks

While bank regulators loved you for buying the zero Credit Risk US Treasuries, to get a reasonable spread over the cost of your deposits, you had to buy 5-to-10-year maturities. Buying intermediate term notes funded by short-term deposits creates another risk, Term Risk. In a rising interest rate environment, the cost of your short-term deposits goes up, but the fixed income of the Treasuries does not. The value of the Treasury notes declines. However, you plan on holding the Treasuries to maturity, so while your earnings may decline, it’s not a big deal…yet.

In 2022, the Federal Reserve Board increased interest rates at the fastest rate and by a higher amount than any time since 1980. As your Treasuries lost 15% to 20% of their market value, people took notice of the large (but temporary, right?) losses on your balance sheet. Analysts sound the alarm, and your depositors begin to flee. Now your problem is not a mismatch of Term Risk, your source of funding is going out the door. You are stuck with realizing losses in the Treasury notes to cover those departing deposits. Regulators step in to keep order in the banking system by selling your bank to a better situated competitor. You are told to hand the keys over to a new bank that acquires all your branches, assets, customer relationships and employees for almost nothing. For bankers, “It’s always something”. If it’s not Credit Risk, it’s Term Risk or Interest Rate Risk or Regulatory Risk or…. the list goes on.

A Familiar Story

Our banking system is a key component of the growth story of our economy. Without it, starting new businesses, building new projects, buying homes and a long list of other transactions would slow to a crawl. Yet, because of the structure of banking (deposits used to finance loans and investments), we’ve experienced several waves of bank failures over the past forty years. Different risks have been the culprits in each case. Whenever the public gets pessimistic, depositors flee from the weak to the strong and the weak go out of business.

Bank failures garner headlines that create a lot of angst. Should I take my money out? Will my bank fail? What does it mean for me?

The Federal Deposit Insurance Corporation (FDIC) raises money through required levies on banks to create an insurance pool to guarantee the safety of depositors’ funds up to a limit of $250,000 per depositor (i.e., joint accounts mean $250,000 for each person owning the account). So, any amounts you have in a bank account up to that limit are safe. Theoretically, amounts over that are at risk if the bank fails. Therefore, it is smart to not have more than that in your bank account. Instead, put excess amounts in a money market fund (not a ‘money market account’), because funds are not considered bank assets and therefore not subject to loss if the bank fails.

However, it is interesting to note that since the 1930s, it appears that very little if any depositor money has been lost in a bank failure. If you search on it, you’ll find some vague references that some depositors “might have lost money” in the state-chartered banks of the Savings & Loan crisis of the late 1980s, but no specific instances of loss. In the big wave of bank failures in 2008-2010, no depositor funds were lost despite very difficult conditions. And none was lost in recent closures. So yes, you should take precautions, but it doesn’t look like there is much practical risk.

Lessons Learned

What should we take away from the curious circumstances that caused the recent bank failures? Foremost is that risk comes in many forms. Hedging against one risk often leaves you vulnerable to another. The recent increase in interest rates may cause investors to buy only short-term (less Term Risk) notes and money funds to avoid the market value losses of longer-term bonds. Yet, if interest rates fall, you will be subject to the bad news of Reinvestment Rate Risk as your interest income will decline very rapidly as rates go down (and with it, your ability to earn a return going forward). Essentially, there is no “Risk Free” position. Thus, we should manage our affairs with an eye on balancing the various risks based on a client’s objectives, time horizon, and cash flow needs. That is how we view our responsibility at High Probability Advisors.