Safety & Stability: Navigating Bank Failures
June 15, 2023
|
Manage Cash Flow,
Markets Plus
- Keywords:
- financial stability
June 15, 2023
|
Manage Cash Flow,
Markets Plus
“Do you remember where you were when you first found out about the liquidity issues that took down Silicon Valley Bank? What was going through your mind? Was it the uncertainty about whether you could make payroll? Were you wondering if your regional bank would suffer the same fate?” Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, asked. It was a stressful time for many business owners, CFOs and corporate treasurers. Even now, making sense of the situation can be difficult.
Shortly after the Federal Reserve announced
it would keep interest rates steady while leaving open the possibility for future rate hikes, and that the U.S. banking system is sound and resilient, four BMO experts—including two who recently joined us from Bank of the West—participated in a very timely panel discussion to help business owners understand the economic and financial impacts of the recent bank failures and how to prepare for what lies ahead.
Our panelists included:
- Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, Moderator
- Scott Anderson, Chief Economist, Bank of the West
- James Fotheringham, U.S. Financial Services Analyst, BMO Capital Markets
- Oscar Johnson, U.S. Head of Commercial Sales for Treasury and Payment Solutions, BMO Commercial Bank
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Following is a summary of the event.
Banking Impact
As Fotheringham noted, the liquidity crisis earlier this year amounted to the banking system’s “very own March Madness” (First Republic Bank and Signature Bank were also casualties). Since then, Fotheringham said, funding stability has returned to the U.S. banking system, though we’re hardly out of the woods. “There is no imminent sign of incremental bank runs, but we believe very strongly that banks, from a fundamental perspective, remain in a very tight spot.”
Fotheringham said there are three fundamental risks still in play: liquidity (in the near term), capital (in the medium term), and credit (in the long term).
Fotheringham said a crisis of confidence and contagion inspired the runs on several regional banks, and the risk for another liquidity crisis remains in play. “The regulatory response to that liquidity crisis was a series of one-off decisions,” he said. “There was no systemic approach to solving the bank liquidity crisis last spring.”
In the medium term, Fotheringham said banks of all sizes face the risk of higher capital requirements. “We were going there anyway. I'm sure that we'll hear about incremental stress scenarios that banks will be put to in future years due to what we learned in March. None of us saw [bank failures] coming, including the regulators, so they are anxious to change how they treat capital on certain types of securities. All of this will result in higher capital requirements for banks, not just for the smaller regional banks, but also for the very large banks.”
Longer term, banks face credit risk, particularly if the Fed goes ahead with an expected two more quarter-point rate increases later this year. “There's no hope for a rate cut later this year as there once was, and it looks like they're quite focused on curtailing inflation, which will inspire some sort of an economic cycle,” Fotheringham said. “Bank credit risk is extremely sensitive to an economic cycle.”
Economic Impact
Anderson said the U.S. economy has so far narrowly escaped the worst of the banking stress. The economy has been resilient, largely due to strong consumer spending and a robust labor market. But he added that we’re bracing for the potential of rising credit losses and delinquencies within a slowing economy. Also, some key economic indicators, such as rising jobless claims and unemployment rates, manufacturing surveys and leading economic indicators, are all trending in a recessionary direction.
There’s also the matter of an inverted yield curve, in which short-term U.S. Treasurys have higher yields than long-term debt. Anderson noted that the yield curve has been inverted for nearly a year and appears likely to remain inverted for at least another year.
"It shows you how restrictive the bond market thinks monetary policy is today,” Anderson said. “The 3 month and 10-yr Treasury spread has been inverted now for about seven months. Historically, after between eight and 16 months of inversion in this spread, you start to get a recession. With the Fed continuing to lean toward a hawkish stance on short-term rates, I think the risk of a harder landing for the United States is certainly there.”
Impact on Businesses
Johnson is in constant contact with CFOs and corporate treasurers trying to navigate this situation. He said one of the common themes that have emerged in his discussions since the banking crisis began is that companies are paying more attention to counterparty risk.
As Johnson put it, "Those who are performing the best are the ones that are most prepared.” He added that the companies staying ahead of the game are diligent with cash forecasting, actively engage with their bankers to discuss liquidity strategies, and understand the importance of payment optimization as a method to unlock working capital from their balance sheets.
"Our clients are now taking a very close look at the soundness of their banking partners and looking beyond their financials, but looking at their regulatory standing requirements, their loan-to-deposit ratios and their deposit mixes. They're thinking about the impact that it's had on them, and they also want to make sure that their banking partners are strong and financially sound.”
As Fotheringham noted, some banks are more exposed to these risks than others. Larger banks and international institutions, for example, have more reliable access to funding. They’ve also been held to higher liquidity standards than smaller banks, so any forthcoming regulatory changes will likely have a minimal impact. That’s why it’s important for CFOs and corporate treasurers to do their homework. That includes understanding whether your financial institution has a solid funding platform, high capital ratios and a diversified loan book.
“We don't know what the economic cycle is going to look like yet, but that economic cycle will have disproportionate effects on different types of assets on balance sheets,” Fotheringham said. “Concentrated exposures can get banks into trouble but having a diversified loan book is extremely helpful going into a crisis.”
How Can You Prepare?
None of the panelists believes we’re out of the woods yet. As Anderson put it, “The panic phase has stabilized, but the patient is still in the hospital.”
From Fotheringham’s perspective, only a systematic approach to tackling the issues that plagued the likes of Silicon Valley Bank will put an end to the situation. “The solution needs to be systemic before we can sound the all-clear signal for bank liquidity. In the near term, we're only a few headlines away from another liquidity crisis of confidence. I hope that the regulators will take a more systemic view toward a solution before we get there. The thing to look for is congressional appetite for a system-wide solution that would come in the form of a blanket guarantee on uninsured deposits. When that comes, then we can sound the all-clear signal. But the political appetite so far hasn't been there.”
In the meantime, Johnson said corporate financial leaders would do well to follow a few basic principles, including prudent cash management. "That means doing cash forecasting, looking for opportunities to maximize yield, and planning for a rainy day similar to what folks did during the pandemic,” he said. “Also, understanding the health and wealth of your bank. Interview your banking partners and look for safety and security.”
"I strongly encourage [businesses and leaders] to make sure you are clear and understand the risks of the financial institutions that you’re partnering with," suggested Dunn. "This discussion is about making sure we're prepared: we need to understand what the options are, what the issues are, what the future may look like, and how to prepare for it."
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Speaker 1:
Welcome to Markets Plus, where leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes. The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries.
Ted Dunn:
Good afternoon, everyone, and welcome. My name is Ted Dunn and I head up Coverage Industries, [inaudible 00:00:33] Finance for Bank of the West. As many of you know, recently joined the BMO family, effective Feb 1. And I really want to start this discussion out with a question. Do you remember where you were when you first found out about the liquidity issues that were hitting Silicon Valley Bank? I think if you're on this call, chances are you remember that moment.
But more importantly, what was going through your mind? What were you thinking about? What became top of mind? If you were on the West Coast and you were banking with Silicon Valley Bank, I think terror might have been a word that was going through your mind. Uncertainty, worrying about whether you could make payroll. If you were with another regional bank, chances are you were wondering, "Gosh, could this happen to my financial institution? What should I be preparing for? What should I understand?" And I think all of these components put together are what this panel discussion is all about. It's making sure that we are prepared and understand what the options are, what the issues are, what the future may look like, and how to prepare for it.
If you recall, I think all of us a year ago were dusting off our recession playbooks. We'd gone through them many times. We probably did sensitivity analysis of different objectives and forks in the road. But the one we probably never thought about was bank failures and the implication on the financial system and more importantly, the implication on our organizations and what they meant.
I don't know about you, but I think most of us got tremendous amount of calls. If you were a CFO or a treasurer, you were getting calls from the board, from ownership, from vendors, from suppliers, trying to understand potential impacts. If you were bankers, you were working very closely with clients or prospects that were affected, making sure that you were taking care of them. And all of these things combined created a new ecosystem for us to worry about. As we sit here today and what this next hour is all about is really a discussion around what that means. And we've put together a distinguished group of panelists here, colleagues of mine that I'm excited to have a discussion with around this topic. Think of it as the financial analyst, you got to have the economist, and then you got that expert, client expert on treasury products.
My name, again, is Ted Dunn. I head up coverage. I introduced myself earlier, you see on the screen now. James Fotheringham. You did see him. There he is. He is financial analyst, part of our capital markets division, knowledgeable on all things financial services. He's going to create some tremendous insights on regional banks' behaviors, what's going on, what the outlook is, where we're heading in that world. Bottom left, you see Scott Anderson, I like to say economist extraordinaire. He was our Chief Economist at Bank of the West, now part of the BMO team. You may have seen him on CNN and many other shows and was a Wall Street top prognosticator, which we were always very proud to have. And his insights are going to be quite useful today, particularly given the recent announcements that have come out in the press.
And then bottom right, you see Oscar Johnson coming to us from Chicago, Head of Commercial Sales of treasury and payment solutions. He has been deep in the weeds with all our clients and his folks. He has gotten tremendous insights and guidance to the corporate client set of BMO and prospects, which I think you guys will find quite interesting. Let's start with James.
James, you're the financial bank expert. This was something I don't think any of us saw coming. What's your view of the impact that this has had date and near long-term vision of what we might expect down the road?
James Fotheringham:
Well, thank you very much, Ted. Thanks for the introduction. Thank you very much for inviting me to join this extremely timely discussion, given the Fed announcement this afternoon. Starting with the US banking system, we had our very own March Madness this year, with a liquidity crisis last March that resulted in the failure of several very large regional banks. Now, since then and recently, funding stability has returned to the US banking system. There is no imminent sign of incremental bank runs, thank goodness. But we believe very strongly that banks from a fundamental perspective remain in a very tight spot.
In the near term, banks are facing liquidity risk. In the medium term, they're facing capital risks. And in the longer term, looking out to next year, they're facing credit risks. Liquidity risks in the near term, capital risks in the medium term, and credit risks in the long term. That's a tight spot to be in. And I just want to unpack each of those three risks. In the near term, my clients, those who invest in US bank stocks, are desperate for assurances on bank liquidity. The crisis occurred and it was a crisis of confidence, and it was a crisis of contagion, which inspired bank runs from several regional banks, both in the US and one very notably over in Switzerland.
The regulatory response to that liquidity crisis was a series of one-off decisions, and that is to say there is no systemic approach to solving the bank liquidity crisis last spring. When depositors at Silicon Valley, for instance, that had uninsured deposits at the bank were guaranteed after Silicon Valley Bank failed, it did not encourage confidence in depositors at other banks. When JP Morgan was gifted First Republic Bank, depositors who were uninsured at other banks did not feel better about that one-off solution, because they felt that there was less of a probability that they themselves might be bailed out in the event of a problem.
I think the solution here needs to be systemic before we can sound the all clear signal for bank liquidity. And I think that solution would come in the form of reenactment of the TAG program, which we put in place during the GFC and was very, very successful at inspiring confidence among depositors. Unfortunately, that requires congressional approval and the politicians aren't there yet. In the near term, we're only a few headlines away from another liquidity crisis of confidence, and I do hope that the regulators will take a more systemic view towards the solution before we get there.
In the medium term, banks face the risk of higher capital requirements. We were going there anyway through a Basel III endgame, as we call it. The regulators were putting in place new regulations as to how to calculate risk weighted assets in regulatory capital ratios. We have a stress test coming at the end of this month, but I'm sure that we'll hear about incremental stress scenarios that banks will be put to in future years as a result of what we learned last March. And the bank regulators are taking a very, very close look.
As you mentioned, Ted, none of us saw this coming, including the regulators. And so, they are anxious to change the way that they treat capital on certain types of securities. All of this will result in higher capital requirements for banks. Not just for the smaller regional banks, but also for the G sibs as well for the very large banks. Again, Basel III end game proposals we expect any day now. The stress test will come at the end of this month for all banks and probably some commentary with those stress tests hinting at what next year's stress test might look like, especially incremental scenarios that incorporate rate risk.
And then sometime later this summer and in the autumn, we expect the regulators to propose changes to the capital treatment of available for sale securities in terms of forcing the market to market AOCI through regulatory capital for all banks with assets greater than 100 billion. But also making changes as to the size, restricting the size of HTM bond portfolios and restricting also the type of securities that can go into those HTM portfolios and the duration on those securities.
And then longer term banks face credit risk. The Fed seems to be, as they announced today, quite determined to continue to hike maybe even two more times. There's no hope for a rate cut later this year as there once was. And it looks like they're quite focused on curtailing inflation, which will inspire some sort of an economic cycle. Well, bank credit risk is extremely sensitive to an economic cycle. If the unemployment rate continues to go up, it will affect unsecured consumer loans. And as the value of commercial real estate, especially office and brick and mortar retail, commercial real estate, as those values, collateral values fall, some banks will be extremely concentrated in terms of those exposures. When rates rise, things within the financial system tend to break, and we've seen that unfortunately this rate cycle. Banks are in a tight spot right now. They're facing near term liquidity risk, medium term capital risk, and longer term credit risk.
Ted Dunn:
Thank you, James. I got a question here. In your mind, as you start to let the haze lift a little bit and we're coming out, and we are in a fairly resilient business here in the financial sector, are there winners and losers, in your mind, that will come out of this? What's your view on that?
James Fotheringham:
Absolutely. And when I'm highlighting risks, there are certain institutions that are much less exposed to those risks than others. On the liquidity side, there are banks with a very small proportion of their deposits, as we call them, runnable. And so, larger institutions in particular, international institutions in particular as well have more reliable access to bank funding. On the capital side of things, I'm afraid the rules will change and force higher capital requirements for everyone. But the largest banks were already held to many of those capital standards that will become new for smaller banks. And so, large banks that were already held to higher standards that boast very high capital ratios are much less exposed, obviously, to incremental capital requirements from the regulator.
And finally, on credit risk, we don't know what the economic cycle is going to look like exactly yet, but that economic cycle will have disproportionate effects on different types of assets on balance sheets. And so, to have a diversified loan book is extremely helpful going into a crisis. Concentrated exposures can get banks into trouble, but diversified loan books really do help. My point on banks being in a tight spot is not necessarily that they're all exposed to these risks, but just those three chronologically tiered risks are driving a lot of uncertainty, which makes it tough from a bank, from an operating perspective.
Ted Dunn:
Got it. And so, if I take that and take it one step further, if I were a corporation, I would be looking and making sure that I understand my financial institution's positions along those curves. Liquidity, credit, capital, as far as really understanding potential risk down the road with those institutions. Is that a fair statement?
James Fotheringham:
Absolutely. Solid funding platform, first and foremost, high capital ratios and a diversified loan book. That's what you have to look for.
Ted Dunn:
Perfect. All right, one last question. We'll make it quick. Why increase capital right now? Why is the Fed going to do that? It's going to tighten credit, it's going to limit capital. Is it the right time to do that?
James Fotheringham:
Well, I think if you're looking at it and your question implies that you're looking at it from an economic perspective, I think there's very little doubt that the regulatory reaction to the bank liquidity crisis will only exacerbate the impending economic cycle. I think that's going to happen. You asked me whether or not it ought to happen, I'm just telling you that it's most likely going to happen. We were going in that direction anyway. I think to answer that question, you needed a bit of history. During the GFC, the banking system had about 3% of capital for all of the assets in the system and that obviously wasn't enough during the great financial crisis.
Post GFC, the regulator forced the bank system to de-leverage. And so, that 3% TCE to TA went all the way up to 9% until about 2016 when there was an administrative change and new regulators came in. And under Trump appointed regulators, the banking system has retraced about half of their de-leveraging efforts post CFC. We now sit around 6% TCE to TA. And I'm not saying that's not enough, but the new regulators who have come in with a new administration were pushing for higher capital requirements because of that historic phenomenon. And definitely, the bank liquidity crisis have only emboldened that effort. And so, we were going higher anyway, but we're definitely going higher for sure. And that's been in the cards for a while.
Ted Dunn:
Got it. Thank you. All right. Let me pivot over to Scott. It's the economist's turn. Big day, big news today, and I'll leave that for you. Scott, your views. How did this liquidity crisis and how does it affect, in your mind, what is happening today in the economic world and where do you think it's headed?
Scott Anderson:
Thanks, Ted. A lot to unpack there. I'd say that we dodged a little bit of a bullet in this banking crisis so far. I mean, the positive spin here, and I think this comes through in the actions of the FOMC today, is they really think a lot of that panic phase of this banking crisis that we're talking about today is largely over. The liquidity facilities that the Fed, the Treasury and FDIC put in place, really backstopped bank liquidity as their lender of last resort. And we're talking about the bank term funding program, the discount window, and the fact that they allowed depositors with greater than 250,000 be made all certainly helped. A lot of that panic phase really happened in March and April, but that doesn't mean all is done and we're all been bracing for the credit impacts.
We know banks from the Fed senior loan officers survey data, that the banks did marginally tighten credit further after the banking crisis occurred. I think the good news around that, if you're looking for a silver lining is it was just marginal. It wasn't a drop jump off the cliff, 2008 looking at the abyss moment, at least at the moment. But I do agree with James that we're entering a more prolonged period of banking stress going forward. And what I'm looking at as an economist is really, its impacts on the economy is the potential for rising credit losses and delinquencies going forward with the slowing economy, which is very much in place and will likely remain in place over the coming year if the Fed goes ahead with a couple more rate hikes.
We're also looking at an inverted yield curve probably for at least another year, and very inverted yield curve compared to historical norms. This means low net interest margins for banks going forward. And of course, slowing loan growth comes along with the slowing economy. We're monitoring all this data from the banks on a weekly basis. We look at the Federal Reserves H8 data and others. What it means, I think, for the banks is that we're entering more of a zero-sum game. If your bank is a strong player, really positioned conservatively, they're in a good position to gain some market share from its competitors, and I think BMO really does enter into that category of bank. But the weaker players are still going to be struggling here. And as I look at the data, it's really quite encouraging. If I look at bank deposits, which were hemorrhaging in March and April, we're looking at 20 or 40% annualized declines on a weekly basis for about two months. It really stabilized in the last three weeks. Total bank deposits are increasing and they're rising at about an 18% annualized pace. Real good news there.
We're also seeing banks not having to access those liquidity facilities the Fed put up as much. In fact, in eight of the last 11 weeks, banks have used less credit that the Fed has made available. That means there's almost very little to almost... There's only 3 billion in borrowing it through the Fed discount window today. Total bank borrowings down, like I said, in eight of the past 11 weeks. We've had a little bit more pickup on the bank term funding facility, but it's up very marginally from April and about 20 billion or so. I think the liquidity situation is stabilized. I'm not saying we're in the all clear, but it's stabilized.
And you did see that in the Fed balance sheet as well. The Fed balance sheet increased by almost 400 billion in the early days of the pandemic, really over a couple week period as the Fed set up these liquidity facilities. But since then, the Fed has continued on its quantitative tightening, banks have paid down some of that borrowing, and so the Fed's balance sheet is down another 340 billion. Almost all that liquidity the Fed put into the banking system in March and April has been taken out of the system today. Again, a sign that things are really stabilizing.
In terms of the loans, we're seeing a very mixed picture there. I think we are seeing some evidence of further deceleration in loan growth, at least the preliminary data we've been seeing for April and May. But it's not, again, falling off a cliff. We're going from overall loan growth around 6% for all bank loans. Now we're down to something like 2.5% growth rates.
But we are seeing categories of loans that are certainly challenged. CNI lending is now contracting. We're seeing it also in home equity lending and auto loans is another category. We're actually seeing declines in lending. We're seeing slowing and residential in credit card lending, but not dropping yet. And then we're seeing... We actually, surprisingly we saw a pickup in commercial real estate lending. I don't know if that's folks really in need of liquidity or all the [inaudible 00:21:47] stuff that's going on, but we haven't really seen that collapse yet in commercial real estate lending, at least if you look at the Fed's data's perspective.
A little bit mixed picture there. I agree with James. I think on in a incremental basis, the bank credit crisis does do some of the work for the Fed. We think it's been equivalent to about a 25 basis point hike from the Fed that we've seen so far. Maybe not what some of the analysts on the street thought it might be, but it's definitely going to help out the Fed in terms of their tightening path. But a lot of that was already baked in to our forecast.
Let me pivot a little bit here and talk a little bit about what it means for the overall economy. I think when I look at the US economy really continue to muddle through here with economic growth. In fact, the economic surprises as the Fed alluded to in their FOMC statement, and I'm sure Jerome Paul is speaking right now in his press conference repeating some of the same messages, is the economic surprises have been largely to the upside. A lot of economists, including ourselves, were looking for some mild pullback in growth, maybe starting as soon as the second quarter. That really hasn't materialized.
In fact, despite rising interest rates, elevated inflation, that continues to be a concern. And the regional banking crisis, the economy continues to grow. And that's the big surprise. That's the big headline right now. So, what is it? It's the resilient consumer. The consumer has just been surprising on the upside, and it really was a couple months. We had a big spike in spending in January around the Social Security Cola adjustment increase of an eight 8.7% increase in incomes. And then in April we got another boost to consumers spending, a lot of that coming around travel and tourism and services demand. But the bottom line is the consumer's still spending. And part of the reason here is the consumer's in good shape. When I look at household balance sheets overall, and that doesn't mean all consumers are in good shape, but household balance sheets are very, very good. If you look at household debt as a share of GDP, it's around 72% in the first quarter of this year. Back before the great recession, it was 100%. People have really pulled back on their debt as a share of the economy. That's good news.
If you look at debt service burdens, households are able to service the debt they have. This debt service burdens are the lowest we've seen. You have to go back 50 years to see them as low as they are today. Now, everyone's worried about inflation, but by our estimates, excess savings from consumers since the pandemic began are still in the neighborhood of about $1.8 trillion of excess savings. Now, inflation is eating that away. About 820 billion has been eaten away of that savings because of the high inflation, but there's still a lot of spending power there.
And [inaudible 00:24:54], this is being backstop by a labor market that continues to outperform. We had 338,000 jobs created last month. We've been trending at 314,000 jobs so far this year. That equates, if it continues at that pace, we could create 3.8 million jobs this year. These are very, very good numbers and it's, again, making the outlook a little bit [inaudible 00:25:18] again when this overall downturn or recession may play out.
Now, with that said, we are still in the mild recession camp or mild downturn camp, and we do think it will start to reinsert itself in the second half of the year. A couple reasons why I say that. One, we're starting to see some tremors in the labor market. Just in the May employment data, we did see a big drop in household employment. That's usually at printing points. That's one of the first categories where you tend to see job loss. We saw the unemployment rate take up three tenths of a percent from 3.4 to 3.7. Still low by historical standards, but economic research has shown that if the unemployment rate rises more than 3.5 tenths of a percent to half a percent in a very short period of time, that's always preceded a recession.
Again, pretty close to recession signals there already. And we just got a big jump in the jobless claims data as well. I'd also point out that the sentiment numbers aren't as good as some of the hard data we're getting from the labor market and the consumer. And you look at things like the purchasing managers indexes for manufacturers and services, it's a pretty downbeat message. Manufacturing has been in contraction territory for seven months now in a row, and the service sector seems to have skipped a beat a little bit in May. Basically, around break even. We're keeping an eye on that.
The other thing I'd point out is the conference board's leading economic indicators, which are 10 indicators, that 10 to lead economic downturns by about six months. That's been showing a negative trend now since the Fed started hiking rates last March. And it's now very strong recession signal still coming from that measure. And so, that's things like housing starts, jobless claims, employment are all included in that measure, along with some of the survey data.
The other couple of things I'm looking at, which the market might not be focusing in on corporate profits in the NIPA accounts, that the GDP accounts that the government produces has actually been negative over the past two quarters. Usually get that happen before companies start to lay off or cut back on their investment spending. That's a negative trend to keep an eye on. The other is the gross domestic income, which if you add up all people's wages and profits in the economy, that's been negative for the past two quarters. Maybe these GDP prints aren't quite as strong as the advanced readings are giving us. It's supposed to equate to GDP. They're certainly going in different directions right now. That's a warning sign.
And I guess my final point would be the yield curve. Yield curve is more inverted today than I've ever seen it going back to the 1980s. That just shows you how restrictive the bond market thinks monetary policy is today. And when you look at some of those measures, the three month, 10 year yield curve has been inverted now for about seven months. You look at past history, usually between eight and 16 months of inversion, you start to get a recession in the United States. We're coming up on that historical record. The average is about 12 months, so we could still go a few more months here if history is in guide. But it does suggest we're pretty close to a downturn here. And the Fed's own recession probability models, which are based on yield curve, just in May gave us 79% probability of a recession in the United States over the next 12 months.
To wrap it up, Ted, it's a very mixed bag. We're really at a turning point here. We're going from this twilight of boom to bust and it's really hard to call when the recession will actually start, given the momentum we still have, but we think we're very close and we think by the second half of this year we'll start to see those negative GDP prints. But very interesting time. And of course, with the Fed continuing to lean to the hocker stance, I think the risk of a harder landing is certainly there.
Ted Dunn:
Yeah. Thank you, Scott. It's an interesting time to be an economist. I'm sure when you were in college and they would've thrown all this at you, you would've been, "Wow, that's quite a [inaudible 00:29:52] thesis." When you look at the Fed, they have to balance two things simultaneously. Monetary policy on the one hand, and then you got financial stability on the other. They don't always go hand in hand, or do they? And how do you think the Fed changes one or the other? Are behaviors being driven by one or the other or not?
Scott Anderson:
Well, thanks for the question, Ted. I do think the Fed's doing a little bit of a juggling act here and maybe a little sleight of hand like a magician would. They're really trying to handle the financial stability concerns and the banking crisis through the liquidity facilities that they've set up, the discount window, the bank term funding program, and through prudential supervision and regulations. Some of the changes that James was talking about that the Fed is envisioning on the regulations side to really help restore stability and soundness to the overall banking system. But that's a really a true track system. And on the other hand, the Fed still is trying to direct monetary policy towards the inflation mandate, which is bringing inflation back down to 2%. They continued to go ahead with rate hikes. They're continuing to threaten to do more rate hikes going forward.
And despite what some analysts were looking for, the Fed has continued to do quantitative tightening. While they're giving banks liquidity through some of these lending and liquidity facilities with one hand, and the other hand, they're taking liquidity out of the banking system through the quantitative tightening program to the tune of about 95 billion a month. We'll see how long the Fed can keep that up, but that's the preference, and then they're hoping that will get them closer to their goal of the 2% target.
Ted Dunn:
Great. Thank you. All right, Oscar, it's your turn. You are living it and breathing it in real time. I think the effect of bank failures and liquidity crisis that banks have really impacted the clients in a real way. Can you share with us your thoughts of what you've experienced during this time?
Oscar Johnson:
Yeah. Thanks, Ted. And happy to engage and also happy to be aligned as one team and one BMO. In our business, we have the accountability for managing treasury relationships with commercial clients. And to add context, when combining BMO and Bank of the West, we're now one of the top five commercial banks in North America. Furthermore, our clients are coast to coast and spans a wide range of industries. We get a good look at what's happening in the economy and what's happening with our commercial clients. We pride ourselves in proactive communication, with a goal of bringing ideas and strategies to our clients and prospects. Most recently, our phones have been ringing excessively with calls from clients and prospects. And some of the common themes that we've heard include the following.
Number one, How safe is the organization? How safe is BMO?" Another thing that we hear oftentimes is, "We have multiple banking relationships and we're not comfortable with some of the banks. How should we think about diversification?" "How can my company maximize yield?" "If we move our business to you, how long will it take to get this process completed?" Some of the questions also that we're hearing from clients relate to conversations that they're having with their boards of directors. And one of them would be, "Our board is asking for clarity on our liquidity strategy. Can you provide perspective on how other clients and or prospects are thinking about it and or making modifications?"
[inaudible 00:33:49] boards are asking CFOs to explore fully insured and other off balance sheet solutions. And corporates are also paying more attention to counterparty risk. Great necessities call out great virtues. And what I take from that is those who are performing the best are those that are most prepared. And what does prepared look like for our clients and prospects that we're having conversations with? Number one, they're super diligent with cash forecasting. They actively engage with their bankers and talk and discuss liquidity strategies. Those who also understand the importance of payment optimization as a method to unlock working capital from their balance sheet.
And then another thing that's really important, and we hear oftentimes, and we've brought it up multiple times as well, is the strength of the banking environment. And our clients are now taking a very close look at the soundness of their banking partners and looking beyond just their financials, but looking at the regulatory standing requirements, their loan to deposit ratios and also their deposit mixes. Our clients are very in tune with all that's going on in the environment. They're thinking about the impact that it's had to them, and they also want to make sure that their banking partners are strong and financially sound.
Ted Dunn:
Thanks, Oscar. One question that comes to mind. If I'm a client, I'm sitting there and I have one bank I've banked with for 20 years and my cash management sits there, my line of credit sits there. There's a sense that there's a need to go broader, that maybe one bank isn't sufficient. Is that the case or is it sometimes the case? When is that? What are your thoughts around when that matters?
Oscar Johnson:
The question comes up a lot and we hear it directly from clients, and I can understand why companies would want to employ or explore deposit diversification. And what we say is number one, and we talk about BMO in terms of what our strength is, and we talk about our safety and how you are safe in instances where you don't have to always diversify your deposit or the number of banks that you're using. One of the downsides that we think about when we mitigate diversification is, number one, the ability to maximize yield and having your funds in one at one institution. The other is it's sometimes inefficient for CFOs and folks in the accounting function to manage multiple banking relationships, and you're using additional time and effort and energy to manage said relationships. Understanding how certain companies' policies are asking them based upon the size of deposits to develop relationships with strong institutions, that's what we're seeing a lot of, and it positively impacts some of the larger organizations that have not been impacted as much.
Ted Dunn:
Yeah, agreed. It's interesting. It's out west where we felt this impact in real time. It was interesting. I think very quickly clients started to realize that they needed to have a checklist, for lack of a better word. As we were bringing on new clients, we were being asked a list of criteria that it had become important, not only from an operational standpoint, which is critical, and that's the hard piece to move, as well as the liquidity. I think that has become the best practice out in the market as we bring in new clients, and I would encourage everyone on this call to make sure that you are clear and understand the risks of the financial institutions that you're dealing with. With that, let me open it up to our panelists, if they have any final words of wisdom for everyone as we wind this thing up.
Scott Anderson:
Can I just say we're not looking at a repeat of the great recession here. As James alluded to, it's not a credit crisis like we had going in to the Great recession. And so, if we can solve some of these liquidity issues, regulatory issues, I think we'll go a long way to solving the problem over the medium term.
James Fotheringham:
I couldn't agree with that more. I think the solutions were difficult to find back in '07 and '08. And today we have the tools. I think we learned a lot from that crisis, and we have a lot of levers that we still haven't needed to pull yet. The system appears stable right now. There isn't a solvency concern. There isn't a credit concern. And on liquidity if need be, there are levers to pull. But as you said very well, Ted, I think clients need to do their homework in a way that they probably didn't feel like they needed to, prior to last March.
Oscar Johnson:
And my closing comment would be aligned with what everyone else said, but it's the three Ps, it's planning, preparation, and also partnership, and those that you're working alongside.
Ted Dunn:
Perfect guys. James, Scott, Oscar, thank you. It's incredibly insightful, candid. Appreciate the nuggets of wisdom I think that we've taken away from this. Amazing. Thank you so much. Hopefully you found this insightful. Look forward to joining and listening to other BMO webcasts in the future, so take care. Thank you.
Speaker 1:
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“Do you remember where you were when you first found out about the liquidity issues that took down Silicon Valley Bank? What was going through your mind? Was it the uncertainty about whether you could make payroll? Were you wondering if your regional bank would suffer the same fate?” Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, asked. It was a stressful time for many business owners, CFOs and corporate treasurers. Even now, making sense of the situation can be difficult.
Shortly after the Federal Reserve announced it would keep interest rates steady while leaving open the possibility for future rate hikes, and that the U.S. banking system is sound and resilient, four BMO experts—including two who recently joined us from Bank of the West—participated in a very timely panel discussion to help business owners understand the economic and financial impacts of the recent bank failures and how to prepare for what lies ahead.
Our panelists included:
- Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, Moderator
- Scott Anderson, Chief Economist, Bank of the West
- James Fotheringham, U.S. Financial Services Analyst, BMO Capital Markets
- Oscar Johnson, U.S. Head of Commercial Sales for Treasury and Payment Solutions, BMO Commercial Bank
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Following is a summary of the event.
Banking Impact
As Fotheringham noted, the liquidity crisis earlier this year amounted to the banking system’s “very own March Madness” (First Republic Bank and Signature Bank were also casualties). Since then, Fotheringham said, funding stability has returned to the U.S. banking system, though we’re hardly out of the woods. “There is no imminent sign of incremental bank runs, but we believe very strongly that banks, from a fundamental perspective, remain in a very tight spot.”
Fotheringham said there are three fundamental risks still in play: liquidity (in the near term), capital (in the medium term), and credit (in the long term).
Fotheringham said a crisis of confidence and contagion inspired the runs on several regional banks, and the risk for another liquidity crisis remains in play. “The regulatory response to that liquidity crisis was a series of one-off decisions,” he said. “There was no systemic approach to solving the bank liquidity crisis last spring.”
In the medium term, Fotheringham said banks of all sizes face the risk of higher capital requirements. “We were going there anyway. I'm sure that we'll hear about incremental stress scenarios that banks will be put to in future years due to what we learned in March. None of us saw [bank failures] coming, including the regulators, so they are anxious to change how they treat capital on certain types of securities. All of this will result in higher capital requirements for banks, not just for the smaller regional banks, but also for the very large banks.”
Longer term, banks face credit risk, particularly if the Fed goes ahead with an expected two more quarter-point rate increases later this year. “There's no hope for a rate cut later this year as there once was, and it looks like they're quite focused on curtailing inflation, which will inspire some sort of an economic cycle,” Fotheringham said. “Bank credit risk is extremely sensitive to an economic cycle.”
Economic Impact
Anderson said the U.S. economy has so far narrowly escaped the worst of the banking stress. The economy has been resilient, largely due to strong consumer spending and a robust labor market. But he added that we’re bracing for the potential of rising credit losses and delinquencies within a slowing economy. Also, some key economic indicators, such as rising jobless claims and unemployment rates, manufacturing surveys and leading economic indicators, are all trending in a recessionary direction.
There’s also the matter of an inverted yield curve, in which short-term U.S. Treasurys have higher yields than long-term debt. Anderson noted that the yield curve has been inverted for nearly a year and appears likely to remain inverted for at least another year.
"It shows you how restrictive the bond market thinks monetary policy is today,” Anderson said. “The 3 month and 10-yr Treasury spread has been inverted now for about seven months. Historically, after between eight and 16 months of inversion in this spread, you start to get a recession. With the Fed continuing to lean toward a hawkish stance on short-term rates, I think the risk of a harder landing for the United States is certainly there.”
Impact on Businesses
Johnson is in constant contact with CFOs and corporate treasurers trying to navigate this situation. He said one of the common themes that have emerged in his discussions since the banking crisis began is that companies are paying more attention to counterparty risk.
As Johnson put it, "Those who are performing the best are the ones that are most prepared.” He added that the companies staying ahead of the game are diligent with cash forecasting, actively engage with their bankers to discuss liquidity strategies, and understand the importance of payment optimization as a method to unlock working capital from their balance sheets.
"Our clients are now taking a very close look at the soundness of their banking partners and looking beyond their financials, but looking at their regulatory standing requirements, their loan-to-deposit ratios and their deposit mixes. They're thinking about the impact that it's had on them, and they also want to make sure that their banking partners are strong and financially sound.”
As Fotheringham noted, some banks are more exposed to these risks than others. Larger banks and international institutions, for example, have more reliable access to funding. They’ve also been held to higher liquidity standards than smaller banks, so any forthcoming regulatory changes will likely have a minimal impact. That’s why it’s important for CFOs and corporate treasurers to do their homework. That includes understanding whether your financial institution has a solid funding platform, high capital ratios and a diversified loan book.
“We don't know what the economic cycle is going to look like yet, but that economic cycle will have disproportionate effects on different types of assets on balance sheets,” Fotheringham said. “Concentrated exposures can get banks into trouble but having a diversified loan book is extremely helpful going into a crisis.”
How Can You Prepare?
None of the panelists believes we’re out of the woods yet. As Anderson put it, “The panic phase has stabilized, but the patient is still in the hospital.”
From Fotheringham’s perspective, only a systematic approach to tackling the issues that plagued the likes of Silicon Valley Bank will put an end to the situation. “The solution needs to be systemic before we can sound the all-clear signal for bank liquidity. In the near term, we're only a few headlines away from another liquidity crisis of confidence. I hope that the regulators will take a more systemic view toward a solution before we get there. The thing to look for is congressional appetite for a system-wide solution that would come in the form of a blanket guarantee on uninsured deposits. When that comes, then we can sound the all-clear signal. But the political appetite so far hasn't been there.”
In the meantime, Johnson said corporate financial leaders would do well to follow a few basic principles, including prudent cash management. "That means doing cash forecasting, looking for opportunities to maximize yield, and planning for a rainy day similar to what folks did during the pandemic,” he said. “Also, understanding the health and wealth of your bank. Interview your banking partners and look for safety and security.”
"I strongly encourage [businesses and leaders] to make sure you are clear and understand the risks of the financial institutions that you’re partnering with," suggested Dunn. "This discussion is about making sure we're prepared: we need to understand what the options are, what the issues are, what the future may look like, and how to prepare for it."
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