Bank Worries | Wells Fargo Investment Institute (2023)

1. May 2023

Paul Christopher, CFA,Head of Global Investment Strategy

Keep track of bank worries

main point

  • Banking regulators have seized control of First Republic Bank and sold most of its banking operations to JPMorgan Chase & Co., the third major bankruptcy by a regional bank since mid-March.
  • Rising interest rates have already overwhelmed many small and regional banks, and there could be more failures in this group. However, the vulnerability of the banking sector to rising interest rates varies greatly. We do not expect a banking crisis.

what it could mean for investors

  • We expect a second echo effect, this time from bank stress to a recession. Financial markets do not seem to be feeling the impact and we have reduced our equity exposure in our portfolio.

What is behind the ongoing stress in the banking system?

Three of the four largest banks in US history have all happened within the last two months. Higher interest rates, particularly short-term rates, have created headwinds across the banking sector, but the balance sheets of all three failing banks are vulnerable to higher interest rates, which have risen more than most other regional lenders. Although these headwinds are likely to continue, we do not expect a new, broad-based crisis for regional banks.

Interest rates fell sharply in 2020 to a 15-year low, prompting a massive inflow of bank deposits (see Figure 1). Families depositing government checks and low interest rates everywhere make the convenience of checking accounts attractive. While interest rates have stayed low during the pandemic, banks are putting their cash to work. Many people are taking out new mortgages.1Another popular option is long-term bonds, which offer banks a sense of security and enough yield to pay depositors and still make a profit.

Figure 1. Rising interest rates increase banking costsBank Worries | Wells Fargo Investment Institute (1)Source: US Federal Reserve Board, Bloomberg and Wells Fargo Investment Institute, weekly and daily data, January 1, 2008 to April 3, 2023. Deposits are shown as a 4-week moving average. The deposit rate is a weekly average of daily US deposit rates averaged across the US by Bankrate.

The sharp rise in short and long-term interest rates over the past year shows the fragility of this strategy. On the cost-of-funding side, today's persistently high deposit balances translate into significantly higher interest costs than in 2020. This is the second lesson from Figure 1. While most banks face this challenge, some special cases for recently failed banks may be exceptions:

  • One bank that went bankrupt in March had the majority of its deposits with large private money managers, most of which were above the FDIC's deposit insurance limits. The closure of many accounts does not pose a solvency issue as questions about the financial health of banks continue to surface. Many banks with a high mix of large and small deposits may not have experienced such a sudden and significant loss of money.
  • Another failed bank linked deposit growth to its lending. Suppose a homebuyer is looking for a $2 million mortgage. Banks offer mortgage rates below the market rate when customers make large deposits with banks, and banks depend on low interest rates to stay afloat. However, should interest rates suddenly rise, the bank's interest costs could soon soar -- just as its below-market mortgages become less attractive to potential mortgage buyers.

This last point illustrates the pressure on profitability. When long- and short-term interest rates rise, the value of assets (mortgages or bonds) can fall, while funding liabilities (deposits) can significantly increase banks' costs. All three failed banks were relatively large regional banks (with assets in excess of $50 billion) that had at least 50% of their deposit base uninsured by the FDIC, according to data from late 2022, and that had outstanding loans and outstanding to maturity held securities in which loans were held exceed 90% of its deposit base.2The lack of diversity in deposits (between insured and uninsured deposits) and the fact that long-term assets make up a large proportion of deposits makes both sides of the balance sheet and earnings very sensitive to rising interest rates.

We may not have seen the last small and regional bank failure. There could be echoes leading the group to close even harder as we expect more rate hikes from the Fed this year. The echo may come at different and unpredictable intervals, but not all of these banks are equally reliant on low interest rates. Importantly, universal banks appear to have more diverse sources of funding, are well capitalized and are subject to strict liquidity requirements.3We do not expect a global banking crisis.

Concentrate on the big picture

We expect another echo effect, this time from the banks on the overall economy and the financial markets. Historically, rising interest rates slow the economy, and then the two forces feed each other, starting with companies overly reliant on low interest rates.

We expect the historical sequence to be restored: rising interest rates increase financing costs, while inflation increases material and labor costs. High interest rates and inflation can also slow consumer spending and reduce corporate income growth. Added to this is the strain on the banking system, which is already restricting lending to households and businesses, while falling profits can no longer support corporate liabilities. Ultimately, the economy will see layoffs and bankruptcies.

Even before the recent bank failures, credit was becoming increasingly expensive and difficult to obtain. Bank interest rates on credit cards and new auto loans have risen sharply since early 2022, hitting a 30-year high in February 2023, according to the latest data from the Federal Reserve.4Small businesses have been feeling the effects of the crisis since mid-2022. A survey of entrepreneurs in March 2023 found that the proportion of entrepreneurs who said it was harder to get a loan was the highest since November 2012.5The financial strain on banks is likely to further tighten lending and bring the recession closer.

Economic support should help cushion the recession - we don't expect a repeat of 2008 - but is unlikely to prevent it. Spending on services and the labor market got off to a strong start to the year. However, spending on services in general has not offset the decline in goods spending and the labor market is often the last pillar of a pre-recession contraction. Any seasonal dynamics in real estate are likely to be temporary as high house prices, weak income growth and rising mortgage rates increasingly weigh on the sector.

our leader

Ultimately, bank stress is an important part of the interest rate environment. Stress levels can vary depending on the diversity that bank managers have created on their balance sheets over the past two years. The entire system is subject to a stricter regulatory and capital environment than in 2008.

The more pressing problem for investors, in our view, is that prolonged periods of higher interest rates and rapid credit tightening are mutually reinforcing, keeping the economy on the cusp of, and approaching, recession. Meanwhile, financial markets are sending mixed signals and we believe downside risks for equities are underestimated. For this reason, on April 21st we reduced our equity exposure and reiterated our defensive positioning in the portfolio.6

12020 and 2021 are consecutive years in which mortgage lending exceeded $4 trillion. See Wells Fargo Investment Institute, “Perspectives on Regional Banking Developments,” March 13, 2023.

2Siehe S&P Global Market Intelligence, „SVB, Signature Racked Up Some High Rates of Uninsured Deposits“, 14. März 2023; und Wall Street Journal, „The Era of Easy Deposits for Common Banks Is Over“, 19. April 2023.

3Further details can be found in UBS, “U.S. Bank Turmoil: FAQs and Investment Implications”, March 14, 2023; S&P Global, “SVB, Signature Accumulate Some High-Rate Undeposits”, Vol. 14 March 2023.

4See the Fed's April consumer credit report (G.19).

5National Federation of Independent Business, Small Business Optimism Index, March 2023, historical data from Bloomberg.

6See our report, Wells Fargo Investment Institute, “Announcement of 2024 Goals and Updated Guidance,” April 21, 2023.

risk assessment

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally depends on the level of return that can be achieved from that investment or asset class.stock marketThe foreign markets in particular are subject to strong fluctuations. Share value may fluctuate depending on general economic and market conditions, as well as the prospects of individual companies and industries.bindingSubject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Changes in interest rates usually have an inverse effect on prices.High Yield Bonds (Junk Bonds).The credit rating is low, the default risk and the capital risk are high.

Sector investments may be more volatile than investments that are broadly diversified across many economic sectors and may increase a portfolio's vulnerability to individual economic, political or regulatory developments affecting that sector. This can result in greater price volatility. Invest infinanciallyService companies will expose their investments to adverse economic or regulatory events that affect the industry.propertyInvesting involves special risks, including the potential illiquidity of the underlying property, credit risk, fluctuations in interest rates and the effects of various economic conditions.

general disclosure

Global Investment Strategies (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and a wholly owned subsidiary of Wells Fargo & Company, a subsidiary of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. The opinions represent the opinions of GIS as of the date of this report and are provided for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or market as a whole. GIS undertakes no obligation to notify you of any changes in its opinions or in the information contained in this report. Wells Fargo & Company affiliates may make reports or opinions that are inconsistent with this report, and may reach conclusions that differ from this report.

The information contained herein constitutes general information and is not directed or tailored to any particular investor or prospective investor. This report does not constitute a customer-specific suitability or best-interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell any security. Please do not rely on this report as the sole basis for any investment decision. Don't choose an asset class or product based on performance alone. Consider all relevant information, including your existing portfolio, investment goals, risk tolerance, liquidity needs and investment horizon. The material contained herein has been compiled from sources and data we believe to be reliable, but we do not guarantee its accuracy or completeness.

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