Markets are Easily Destabilized by Precarious Bank Funding Model

May 4, 2023 | Bubble Monitor, No Bull Economics

Bubble Monitor 5.4

Rapid interest rate hikes are stressing the prevailing banking business model which relies on fickle short-term deposits to fund long-term loans & investments.

Commentary

  • Initial 1Q23 earnings provide encouragement that the economy is recovering (please refer to our recent posts), and all would be well if not for concerns about the banking system. 
  • Notably, the banks were happily minding their own business when their boss at the Fed recently decided to raise interest rates after leaving them near zero since the 2009 start of the Great Recession. While it makes sense for the Fed to normalize rates, the frenetic pace at which this objective was accomplished has created significant pressure on our fragile banking system. This also has important implications for the stock market.
  • Banks are in business to make long-term loans & investments with funding provided by demand deposits. However, as interest rates rise, depositors can easily move their money out of the banks into high-yielding money market accounts and/or T-Bill-like investments. While the banks could try to raise their deposit rates to keep their funding source in place, their portfolios of low-yielding long-term loans & investments wouldn’t pay for their added funding costs.
  • Another problem with a rapid rise in interest rates is the impact it has on the present value of long-term bank holdings. Many banks invested depositor money in safe treasury bonds, only to find that these investments depreciated substantially as interest rates climbed higher.
  • As indicated by the table below, a 10-year Treasury with a 2% coupon could be purchased by the banks for 100% of face value ($1,000) at a time when the market interest rate was also 2%. If interest rates drop, the banks make money. However, higher interest rates drive a lower face value for their long-term investments.
  • Notably, a market interest rate increase from 2% to 6% drives a nearly -30% decline in face value. Not a problem if the bank can hold the bond to maturity. Also, the banks are currently permitted to use underwater bonds as collateral for full-face-value loans from the Fed, helping provide liquidity to fund deposit withdrawals. No matter, if all the scary dynamics of a rapid interest rate increase are sufficient to spook depositors at a weaker financial institution, then we have a run on the bank…      
Interest Rate Bond Price Chart
  • What’s the solution? The Fed needs to better acknowledge that its interest rate policy impacts more than just inflation, consumers & jobs but also has the potential to destabilize our precarious financial system. For this reason, interest rate hikes should be implemented gradually over a sufficiently long period of time to allow consumers, employers & the very important banking system to adapt.  
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