Trading in shares of First Republic Bank and Western Alliance Bancorp. was paused after steep initial losses on Monday as bank solvency fears persisted following the failures of Silicon Valley Bank and Silvergate last week. First Republic is down almost 75% and PacWest down almost 40% today.
We believe that it has more to do with available liquidity to total deposits and the mechanics around the Fed’s new Bank Term Funding Program (BTFP). It comes down to eligible collateral. Eligible collateral is U.S. Federal guaranteed securities (U.S. Treasuries, MBS and CMBS) and does not include municipal securities or other private MBS, CMBS or CMO or other structured products. Structured products may be more difficult to sell given general lack of secondary liquidity.
However, we note that interest rates have come down about 30 bps (10-year UST) from December 2022, so we expect that the mark-to-market losses below are overstated on non-eligible securities BTFP. As bond yields drop, these long-duration securities increase in value.
Regional banks have relied on municipal securities and other private securities in their securities book to improve net interest margin, as these securities tend to yield higher than U.S. federally guaranteed securities, given higher credit risk associated. This also relates to our earlier note, that the lack of the Liquidity Coverage ratio requirement has allowed U.S. Regional banks to allocate more of their securities portfolio to these securities given that LCR is punitive to anything other than Level 1 HQLA (essential US Treasuries, Cash) and Level 2 securities are limited to 40% of the overall portfolio.
Based on our interpretation of the way the BFTP works is a 1-year loan that is collateralized by U.S. Federal guaranteed securities. This will allow regional banks to obtain liquidity to meet deposit outflows and reset their interest rate risk management positioning over the next 1-year.
The fear with First Republic and PacWest is the concentration with Venture Capital/Technology firms placing large uninsured deposits and percentage of US Federal guaranteed securities vs. other securities which is why stock prices are down despite the announced liquidity backstop (see Table 1 below).
Though the liquidity profile of these banks have improved, the maximum exposure to deposit outflows is greater than liquidity potentially available as of now as to what we have been able to surmise based on publicly available information. Time will tell if deposit outflows will outstrip liquidity available and the deposit run/confidence crisis continues.
We believe, even if these banks sell their non-eligible BTFP securities and realize losses to help stem further deposit outflows, the Total Capital ratios for these banks should be above minimum standards (this was the issue that caused Silicon Valley Bank to fail).
However, this does not consider future impact on earnings and existing operations or new regulatory requirements (including more stringent stress testing) and potentially impacts the Capital/Liquidity ratios. Uncertainty and fear create potential opportunities.
This whole situation will cause many rethink bank regulations and how risk is transferred rather than transformed in economy (from large banks to small banks around these uninsured institutional deposits), as well as, common place Treasury-related risk management (interest rate risk, liquidity and counterparty credit risk limits for Corporate Treasurers) and potential for new/expansion of businesses such as deposit brokers diversifying excess liquidity within insured deposit limits.
Table 1 – Comparing First Republic and PacWest Contingent Liquidity Positions