Overview
Though U.S. Regional Banks do not measure their liquidity position under Basel III Liquidity requirements, we have tried to estimate a proxy for a Liquidity Survival Horizon based on deposit withdrawals that have been used by banks/regulators in the Liquidity Coverage Ratio (30-day liquidity stress test) and look at other historical examples of bank runs that have been on a more sustained basis (> 5 days) to get a sense of how long First Republic (FRC), Western Alliance (WAL) and Pac West (PACW) may be able to survive a sustained bank run on deposits.
Despite what you hear in the media, the issue is largely a liquidity issue (regaining depositor confidence to reduce deposit flight out of U.S. regionals) rather than a capital/solvency crisis related to unrealized Held-to-Maturity (HTM) securities portfolios.
These bank’s stocks have been quite volatile over the past week (currently trading below Tangible Book Value even after adjusting for losses on securities and potential losses on venture capital lending), even after the U.S. government authorities have provided de-facto support to uninsured depositors in Silicon Valley Bank and Signature Bank bail failures.
The situation at each of these banks is very different than what occurred at Silicon Valley Bank (SVB) (i.e. have not taken on as much duration risk as SVB through securities book, do not have the same management/governance issues, and have been historically well-run banks with long customer relationships).
We believe this is a crisis of confidence, along with a re-rating of the potential economic outlook as a result of near-term further tightening of credit conditions and potentially paying elevated costs for deposits and wholesale funding. It remains to be seen over the long term if there are changes to the fundamental characteristics of the underlying businesses. We believe some enhanced prudential regulation may be warranted at the U.S. regional banks to ensure a consistent level of testing for capital/credit, liquidity/funding and interest rate risk.
To provide perspective on the amount of credit creation in U.S. regional banks vs Large Banks and the importance of U.S. regional banks to the overall U.S. Financial System, small banks have provided 45% vs 55% from large banks of all lending growth into the economy since 2010. So the financial stability and trust within the regional system around the safety and stability of the deposit base are critical to continue to provide lending to the economy.
Table 1 – Lending Growth – Large vs Small Chartered Banks
By March 24, we will get a sense of the aggregate deposit outflows from Small Chartered Banks (U.S. Regional Banks) vs. Large Chartered Banks as we get an update on the aggregate deposit balances from the week of March 15th. It is hard to assess the amount of deposit outflow, though rating agencies (Moody’s/S&P/Fitch) have downgraded/put on negative watch the U.S. regionals (including cutting First Republic to non-investment grade). However, these actions are more of a lagging indicator and more akin to the action of closing the barn doors after the horses have escaped.
Looking at the Fed Balance Sheet released today, there was an increase of $300 billion week-over-week in response to the ‘Liquidity stress’ by adding additional liquidity to the banking system to increase liquidity on banks’ balance sheets as many banks enacted their contingent funding plans to deal with potential deposit outflows:
1. $148 billion of Fed overnight discount window lending
2. $11.9 billion from the new Bank Term Funding Program
3. $142.8 billion of lending to depository institutions backed by collateral & FDIC guarantees.
Table 2 – U.S. Federal Reserve Balance Sheet
We do not have any further information on which banks would have tapped the discount window, BFTP, and other guarantees.
The real risk in the short term for each of the U.S. regional banks is how long they may be able to sustain the liquidity risk (deposit outflows). We have attempted to calculate the exposure and how long each bank may survive based on stress testing via regulations.
Also, the reduction in interest rates over the past week has likely reduced the unrealized losses in securities portfolios, and as a result the reduced the negative impact on the capital ratio, should these portfolios be sold to meet deposit withdrawals.
The regional banks have a similar business model, borrow short via largely non-maturity deposits and lend long and earn a spread called net interest margin for managing maturity mismatches and underlying credit risk.
Loan books for most U.S. regionals have weighted average maturity between 7-10 years and are largely funded by non-maturity demand (NMD) of both retail and commercial clients. These NMD deposits’ weighted average maturity is determined largely through statistical analysis of related “stickiness” of the deposit base based on “deposit betas” based on cohorts and underlying characteristics (under market stress like we are seeing the past week, which make deposit withdrawal or runoff more likely). This information is not available publicly and internal Treasury teams would be reviewing the “stickiness” and “beta” on an ongoing basis.
Without a stable deposit/funding base, banks will pull back on lending into the real economy (including tightening of credit standards to give money only to the most creditworthy business and consumers) slowing credit creation within the economy, especially to middle market clients that the U.S. regionals serve. The resulting credit crunch forces companies to cut prices and labor costs by cutting wages and payroll, which tends to slow the activity in the economy, eventually causing a recession.
In an inverted yield curve environment, lending usually slows, as net interest margins may be compressed as deposit costs rise faster than lending, given that for most banks the effective maturity on the asset side of their balance sheet (say 30-year mortgage) is greater than effective maturity the on liability side of the balance sheet (say non-maturity operational deposit 3-5 years) – this is maturity transformation and along with credit risk, is the reason that banks earn net interest margin.
With the inverted yield curve and credit contraction resulting in a recession or economic slowdown, the Federal Reserve is likely to cut interest rates and reduce margin compression due to higher deposit costs and will start credit expansion again. Over the past week, we have seen a deflationary impulse due to the potential for credit contraction due to funding instability, and the Federal Reserve may need to prioritize Financial Stability relative to inflation concerns, and the speed of the rate hiking cycle.
Liquidity Stress Tests: Covering the Basics: A Background on Deposit Runoffs and Other Cash Outflows
In Basel III banking regulations, there is a framework that helps banks determine their liquidity risk profile by setting minimum standards and measures which include the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
As we have noted in our earlier reports on Silicon Valley Bank (SVB), given the $250 billion threshold (asset size), U.S. regional banks have not had to adopt capital and liquidity stress testing on an ongoing basis, similar to the Global Significant Banks (G-SIBs) (JP Morgan, Citigroup, etc.). So this means, that they do not have to report their Liquidity Coverage Ratio or Net Stable Funding Ratio.
Since adopting Basel III rules, G-SIBs have repriced low-quality deposits (i.e. institutional fast money deposits) and many of these deposits may have found their way into the unregulated space U.S. regional banking space such as SVB, FRC, WAL, and PACW. Given the potential for impact on G-SIBs’ Liquidity and Funding ratios, it may be a difficult decision for G-SIBs to acquire the deposit base given the regulatory overhang.
We will attempt our best to apply this regulatory framework to the U.S. regional banks, though given there is limited information publicly available, we would say these estimates are very high level. Banks that have adopted these regulations would rely on a lot of underlying consumer data to help determine the proper classification of a particular deposit or loan product. But on to the basics of bank stress testing before the application.
The LCR is meant to measure emergency funding capacity over a short period (30 days) to see if a bank can withstand liquidity stress over 30 days, with limited capacity to obtain additional funding (i.e. no additional deposit or wholesale funding inflows to refinance existing maturities) to continue ongoing operations.
It is the ratio of the amount of ‘High-Quality Liquid Assets’ or HQLA you have available, compared to a rough-and-ready estimate of the cash outflows you might experience over 30 days if your wholesale funding dried up and some (but not all) of your retail and corporate deposit was withdrawn.
The ratio is meant to be above 100% and represents a 30-day “survival horizon” based on available liquidity that is on the bank’s balance sheet.
- The bank’s deposit liabilities are risk-weighted based on the likelihood that depositors withdraw their money in the 30-day stress period. Retail consumers are less likely than more sophisticated clients such as Commercial customers or Financial Institutions to withdraw their deposits based on prior studies of bank runs. These larger institutional clients will have larger deposits that are uninsured under deposit insurance programs.
- If a bank holds an LCR ratio above, 100%, they will have the “Liquidity Survival Horizon” based on existing liquidity resources will be greater than 1 month.
- Typically, based on historical episodes of liquidity stress/deposit runoff do not last for months at a time, as regulators/Treasury will try to regain Financial Stability and quell fears of an ongoing run on confidence.
- Banking is built on trust, as in that, clients’ deposits are safe and can be used when the customer wants to use them. Headlines or market volatility cause unwarranted panic and erode customer trust and confidence in the safety of the financial system.
The NSFR — is also meant to be above 100%, which measures structural funding liquidity to ensure that maturity mismatches are manageable over a period of > 1 year. It is a ratio of the two sides of the bank’s balance sheet after each side is adjusted for structural liquidity risk (greater than 1 year). Assets are assigned weightings according to how easy they are to turn into cash or how illiquid they are to enable deposit withdrawals from the bank.
- Short-term Treasury bills get 100% Liquidity value (Required Stable Funding = 0%), while longer-dated corporate bonds get 50% (Required Stable Funding = 50%) and loans get zero.
- Liabilities get weightings according to the likelihood that someone will want cash back immediately. So overnight repo is weighted at 100% and retail deposits are 90% (Available Stable Funding = 90%). “Hot money” wealth management (0% Available Stable Funding) and corporate deposits only get a 50% weighting (Available Stable Funding)
- If the ratio of the first number to the second is above 100%, then broadly speaking, long-term and illiquid assets are matched by an equivalent amount of long-term and stable liabilities.
- Non-maturity deposits from retail consumers have linkages such as payroll and/or bill payments which tend to be covered by deposit insurance and are favored versus large corporate clients or financial institutions which tend to be flighty in a stress period given that their deposits are largely uninsured. Operational deposits for cash management are favored from a liquidity perspective relative to non-operational deposits.
- With the actions announced by the government on Sunday, of implicitly guaranteeing uninsured deposits (above $250k), we believe that it is more likely that consumers are to stay with their institutions rather than move their entire relationships over, though there will likely be some withdrawals which both NSFR and LCR account for in their risk-weighting under stress.
Applying Liquidity and Funding Stress Tests to Select U.S. Regional Banks
Available Liquidity (HQLA + Contingent Liquidity) – Short-term Liquidity (<1 year)
Available Liquidity appears to cover about ~80-110% of uninsured deposits (Q4/22) at the below select U.S. regionals (see Table 3 below) and appears that most banks have enacted their Contingent Funding Plans. Replacing low-cost NMD deposits with FHLB/FRB funding or high-cost deposits/funding as a result of deposit outflows is expected to reduce the net interest margin in the short term.
Table 3 – Available Liquidity (HQLA + Contingent Liquidity) at Select U.S. Regionals
Proforma Net Cash Outflows and LCR at Select U.S. Regionals
Below we have attempted to quantify the deposit outflows based on limited information in public disclosure documents. We find that from an LCR and NSFR perspective, these banks should have enough liquidity to withstand outflows that have been assumed by the regulatory framework over the next 30 days (if contingent liquidity is drawn, range between 140-270% of 30-day stressed outflows).
Despite the different business models/mix between Retail/Commercial deposit bases, we find that all three banks potentially have a weighted average runoff rate on deposits at roughly 27% – See Tables 4-6.
Looking back at historical bank runs for comparative purposes, we find that 27% appears to be on the high end (see below). We note that deposit velocity outflows at Signature Bank (SBNY) and Silicon Valley Bank (SIVB) were much faster than previous bank runs as well given the speed of technology. At this point, we do not have any concrete evidence of the magnitude of the actual deposit outflows over the past week.
We note that First Republic appears to have a more concentrated deposit base relative to the others, as average commercial deposits are $500,000/account and average personal accounts of $200,000, representing roughly 550,000 clients. The franchise is a high-touch/high-service business model to serve wealthy entrepreneurs.
The question is if this business model is sustainable if inflation is sustainable and rates remain higher for longer which may increase deposit funding costs with more interest rate sensitivity as deposits reprice higher relative to loans that are typically long-term mortgages that have a much longer effective maturity. It is likely the speed of the Federal Reserve changes and additional stimulus that has likely had an impact as well on the repricing of both loans and deposits since 2019.
First Republic has only approximately 1/5th the number of deposit accounts compared to the average $100–250 billion U.S. bank, which enables a greater ability to provide extraordinary service and oversight per relationship and has an average client relationship length of 24 years. Deposit betas across the entire deposit books based on the latest rate hiking cycle (2022/23) have been 8% (FRC), 12% (PACW), and 10% (WAL) over the past year.
With the downgrade of First Republic at S&P/Fitch to BB+ (junk/non-investment grade) from A-, citing deposit outflows and general weakness in funding & liquidity, may also impact some corporate deposits as investment committees/corporate treasuries require their counterparties to be investment grade as a result of their Investment Policy Statements. The impact of the downgrade is yet to be determined as to how much it may impact deposit outflows. Given the immateriality of derivative activities, we have not considered the impact related to a 3-notch downgrade below.
Typically a downgrade of one notch equates to roughly 25 basis points of additional borrowing costs for a company. However, a four-notch downgrade signals greater potential problems for a company and could result in more stringent loan requirements such as giving up equity for more permanent sources of capital (including deposits and potential equity infusion from larger banks, which may help regain confidence from the general public).
Today it was disclosed that First Republic is to receive up to $30 billion in deposits from Bank of America, JPMorgan, Wells Fargo, Citigroup, Morgan Stanley, and other lenders (with the blessing of the U.S. Government) to provide more permanent sources of capital to replace deposit outflows and restore confidence and trust in the U.S. regional banking system. This amount would represent about 18% of First Republic’s total deposits.
So over the past week, government authorities have implicitly guaranteed uninsured deposits and provided a new liquidity facility, JP Morgan provided an unsecured line of credit and a syndicate of banks and larger significant banks have deposited funds into First Republic Bank.
These three actions are thought to provide further trust and confidence in the functioning and stability of the U.S. Financial System including smaller U.S. regional banks, and hopefully reduce equity market volatility.
Table 4 – First Republic Bank: Proforma Net Cash Outflows and LCR
Table 5 – PacWest: Proforma Net Cash Outflows and LCR
Table 6 – Western Alliance: Proforma Net Cash Outflows and LCR
Short-term Liquidity Survival Horizon
Below we estimated based on the net cash flow assumptions above continuing net cash outflows beyond 30 days to see how long could these banks survive without any additional funding (deposits and wholesale funding) based on their cash/securities portfolio + known contingent liquidity available.
We note that First Republic has been more responsive in the past week and prepared itself for further deposit outflows by raising additional liquidity, despite the government de-facto supporting uninsured depositors, by securing additional liquidity and shoring up contingent liquidity. Contingent liquidity has been raised by pledging assets to FHLB/FRB at almost 62% (as of Dec 31/22) of their balance sheet, which is double the amount PacWest and Western Alliance have pledged ~30%, potentially due to more collateral secured by residential real estate.
First Republic, PacWest, and Western Alliance have an estimated survival horizon of 3.5 months, 1.5 months, and 1 month respectively (see Table 7). This liquidity buffer may allow the banks breathing room to help raise additional capital or negotiate a sale or equity infusion from larger banks to provide permanent capital to replace potential “core deposits” that have left the bank in deposit outflows.
We note that these banks may raise their survival horizon in the short term through the Federal Reserve Bank Term Funding program (up to 1-year collateralized loan). We note that the survival horizon is based on assumed deposit runoffs based on the underlying deposit characteristics of each balance sheet. The survival horizon could be potentially much shorter if deposit withdrawals are much faster than regulatory parameters which are calibrated based on historical bank runs.
We note that the bank runs at Signature and Silicon Valley Bank were much faster than previous bank runs given the speed customers can move cash across the existing financial system.
Table 7 – Liquidity Survival Horizon – Select U.S. Regional Banks
Structural Liquidity (Liquidity >1-year) – Net Stable Funding Ratio
We have attempted to estimate NSFR based on our high-level estimates based on publicly available data (see Tables 8-10). Generally, it appears that the U.S. Regional Banks reviewed generally do not appear to have structural liquidity gaps (i.e. funding too many illiquid assets with short-term deposits/shorter-term wholesale funding consider stressed parameters).
We note further information on Corporate Deposits would be required to firm up these estimates to see how much of these deposits are related to Financials/Financial Intermediation, as Financials tend to have higher outflows relative to corporates. Also, Small Business vs corporate delineation could provide some reprieve on liquidity requirements, as small businesses tend to have lower runoffs relative to corporates.
However, we note that if stressed deposit outflows were greater than regulatory parameters for available stable funding, then a structural liquidity gap would exist. This is why these banks may look to raise equity or equity-like permanent capital to replace any relationship deposits that have a runoff.
One observation is that the banks currently do not have a lot of term deposits and most of the funding is through non-maturity deposits. Fixed-term funding tends to be more costly given that it is outstanding for a longer period. Non-redeemable fixed term deposits which have been laddered over time to approximate the loan book maturity have been a very useful way to diversify funding and solidify the balance sheet if a deposit run on non-maturity deposits is to occur as maturity and amount is known well in advance. Term deposits at Canadian alternative mortgage lender Home Capital solidified the balance sheet (which they had a greater reliance on relative to non-maturity deposits) when there was a run on non-relationship non-maturity deposits in 2017 and have remained a going concern to this day.
Table 8 – NSFR Estimate – First Republic Bank
Table 9 – NSFR – PacWest
Table 10 – NSFR – Western Alliance
Historical Examples of Deposit Runs and Monthly Runoff
We have reviewed the hypothetical LCR deposit runoffs relative to historical cases in Table 11. The median deposit run has lasted 2 weeks, though there is high dispersion and each case has been unique. We note that LCR runoffs of 27% are about 1.5x the amount of historical median runoffs at 18%, so this gives us some confidence that our hypothetical estimates of liquidity survival horizon are conservative.
Table 11 – Historical Examples of Deposit Runs and Monthly Runoff
Reported Deposit Flows in March From Small U.S. Chartered Banks to Large Banks
Earlier this week, we noted that Bank of America said that they have received $15B in deposit inflow over the last week. We have extended this analysis of $15B inflow/week to each large bank which would equate to about $300B inflow to the large banks in 30 days (see Table 12).
We have compared these deposit outflow assumptions relative to the LCR runoff assumptions for the remaining U.S. Regional players (FRC, PACW, and WAL). While this analysis is extremely speculative and high level, it supports that the LCR stress runoffs should suffice for a reasonable assumption of potential deposit outflows over 30 days relative to the information we have received to date from Bank of America. We suspect that some of the deposit outflows from banks have been invested in U.S. Treasuries directly as well, however, we are not able to quantify this amount.
In this type of analysis, the devil is in the details and relative outflows are extremely important when considering the impact on each bank’s current specific liquidity and funding position. It does provide us some assurance that the actual deposit outflows are potentially lower than that assumed in LCR.
Table 12 – Proforma Deposit Flows over 30-day Period From Small U.S. Chartered Banks to Large Banks
Pledged Assets, Contingent Liquidity, and Unencumbered Assets for Further Liquidity
The next question we ask, is now that we know that it is likely that the select U.S. regional banks have enacted their Contingent Funding Plan, how much additional balance sheet capacity do they have to pledge to extend their liquidity survival horizon even further than our baseline analysis?
The Federal Home Loan Bank (FHLB) System was created by the Federal Home Loan Bank Act of 1932 as a government-sponsored to support mortgage lending and community investment. The System is composed of 11 regional banks which are privately capitalized and owned as cooperatives by their members. Their regional distribution enables each bank to focus on the needs of their individual communities.
FHLBs carry out their core mission of providing liquidity by raising funds in the global financial markets, then lending that money in the form of “advances” (loans) to members and local communities when liquidity is required.
The FHLBs cap the amount of advance credit available to each member at between 20% and 60% of the member’s total assets, with some exceptions available depending on member creditworthiness.
In periods of extreme liquidity stress, banks may also pledge their assets to the Federal Reserve via the discount window, though there is a stigma attached to drawing funds from this source. Federal Reserve lending to depository institutions (the “discount window”) plays an important role in supporting the liquidity and stability of the banking system and the effective implementation of monetary policy.
By providing ready access to funding, the discount window helps depository institutions manage their liquidity risks efficiently and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress. Thus, the discount window supports the smooth flow of credit to households and businesses. Providing liquidity in this way is one of the original purposes of the Federal Reserve System and other central banks around the world.
We note that First Republic has encumbered about 60% of assets (Table 13) and has about $20B in unencumbered liquidity that it can draw from government entities (FHLB and Federal Reserve). This would likely extend the liquidity survival horizon to 3 months. Given that they have pledged a large portion of their balance sheet, this is likely why First Republic Bank is reviewing all strategic options, including the sale of equity to provide further permanent capital.
On the other hand, PacWest and Western Alliance, have pledged about 30% (Table 13) of their balance sheet. It is likely given the underlying collateral (more unsecured commercial loans relative to secured residential real estate loans), borrowing capacity as % of the balance is likely lower than First Republic. If they can increase the borrowing capacity based on unencumbered assets, at a high level this would extend the liquidity survival horizon of PacWest up to 5 months and Western Alliance to 4 months (although a detailed analysis of collateral haircuts of underlying loans would need to be undertaken).
Table 13 – Pledged Assets and Contingent Liquidity
Bank Solvency & Capitalization – Capital Ratios – Where Do we stand?
Bank Solvency/Capitalization appears strong and underlying collateral appears to be performing at this point in the cycle.
We note, that after considering mark-to-market losses as of Q4/22 on Non-eligible securities for Bank Term Funding Program, as well as, lending to venture capital against shares (taking a 50% haircut as a conservative estimate), capital ratios would be below 10.5% total capital requirement for all banks.
Similar to exceptions during COVID-19 around higher-than-average issuance of Sovereign Bonds which impacted the Leverage Ratio negatively, we wonder if bank regulators may temporarily provide some relief/discretion for non-eligible Bank Term Funding Program securities (i.e. Muni Bonds, Corporate Bonds) or potentially widen out the collateral for Bank Term Funding Program similar to Federal Reserve Discount window. These potential changes would need to be handled very carefully not to allow for moral hazard or excess optimization/risk-taking and support the financial stability of the U.S. Banking industry.
With interest rates falling as much as they have in the past week, we believe the unrealized mark-to-markets on securities would have reversed, so this is a conservative estimate of tangible book value and capital ratios in Tables 14 and 15.
We can conclude that with these regional banks, the story here is much different that Silicon Valley Bank and Signature, as they appear to remain solvent at this point. With the potential for credit contraction and margin compression, the story in the short-term is continuing to have strong liquidity and being able to withstand deposit outflows and maintain net interest margins.
Table 14 – Price/Tangible Book Value – Select U.S. Regional Banks
Table 15 – Capital Ratios – As Reported and Adjusted (Q4/22)
Other Potential Actions to help Extend Liquidity Survival Horizon and Strengthen Capital Ratios – Contingent Plan (not considered in Liquidity Survival Horizon above)
- Further liquidity via Bank Term Funding Program/FRB Discount Window
- Collateralized Secured Funding Raise (Securitization of Loans/Residential Mortgages)
- Suspension of Common Dividend
- Increase efficiency/reduce costs
- Other Strategic Options: Capital Raise/Sale/Merger to Larger Bank. In First Republic’s case, RBC may re-approach the First Republic about a merger deal. In the past, RBC has been rejected by the First Republic. It may be a good strategic fit with City National Bank as well. JP Morgan and Morgan Stanley may also be interested as well.
Credit Contraction and Replacing Low-Cost Deposits with Bank Term Funding Program to meet near term liquidity needs: Impacting Fundamentals via Net Interest Margin Compression?
Below we have estimated, the impact of low-cost deposits of withdrawals being replaced by a more expensive Bank Term Funding Program assuming that 30 days’ worth of withdrawals is replaced by BTFP costs (one-time shock).
For example, at First Republic, the replacement of the low-cost deposits of 0.4%, by a more expensive Bank Term Funding Program of 4.50% is 10x the existing funding cost.
In First Republic’s case, given the overall asset mix of more secured real estate lending which represents almost 60% of the loan book (low credit risk and low margin), it may be difficult from a profitability perspective, in the long-term to continue this business model without significant change as having a significant portion of low-cost NMD deposits (say 25% of total deposits), are replaced with Bank Term Funding (1-year secured funding) or Wholesale funding costs.
This is potentially why First Republic is reviewing all strategic options including sales to reduce the cost of funds back to pre-SVB failure by partnering with a strong/stable large bank such as RBC. Replacing low-cost NMD, higher-cost BTFP, or wholesale funding would reduce annual profitability by almost 90% (see Table 16). Given that the business is focused on high touch/high service, the model is quite expensive to maintain over the long term as well and if First Republic’s cost of funding has been permanently impaired, then questioning the high touch/service model may also be on the table.
It appears that earnings in the next 12 months (if FRC can secure BTFP or discount window funding) would be positive as long as deposit runoffs stay below ~30% of overall deposits (assuming a limited change in overall funding costs from current levels) and there are no significant losses on their loan book. The real question is how loyal are the customers to this bank and if they are willing to give up their long-standing relationship – given that bank has a strong franchise and very loyal customer base and has served wealthy/sophisticated clients for roughly 25 years on average with FRC.
This is a temporary situation as they are enacting their liquidity contingency plan, especially when the yield curve is inverted (new loans origination at longer-term rates is falling and short-term rates are rising increasing funding costs), causing further margin compression.
Tapping the Federal Reserve’s Bank Term Funding Program likely extends the Liquidity Survival Horizon further (up to 1 year) and allows the banks to try to secure a cheaper source of funding/capital that is longer-term in nature, over that year, including regain customer deposits via confidence/trust.
Another way to think about the situation is that we are likely, close to the end of the interest rate hiking cycle as there are signs that inflation is starting to come back down to the target and as a result, the likelihood of elevated funding costs at this current level, is not likely to persist in the long-term interest, as rates tend to be mean reverting based on long-term rates of inflation and real GDP growth over time.
This is likely why First Republic is considering a sale, as an infusion of equity capital in the place of deposit outflows would be a permanent source of funding and allow it to continue its high-touch business model (should interest rates remain elevated) without significant changes to customers who have remained loyal and margins would remain relatively similar.
Looking at PacWest and Western Alliance (see Tables 17-18), margin compression is expected to be more muted than First Republic given the larger Commercial Loan book with a higher interest margin when considering replacing potentially 1 month of deposit outflows (not considering the impact of potential higher loan losses due to reduction in credit availability/potential recession). The negative Earnings impact of such a replacement of deposits at PacWest and Western Alliance would be ~70% and ~40%, respectively.
Also, their commercial loans (higher proportion at PacWest/Western Alliance) appear to be more rate sensitive as 60% of the loan book is floating rate, with a shorter average term profile of 5 years relative to FRC 90% fixed rate vs 10% floating with an average maturity of 11 years. From a credit risk perspective, FRC losses would be expected to be lower, relative to PacWest/Western Alliance) and may this play out as part of the next step in the credit cycle, as credit potentially contracts.
As long as all three banks can manage deposit outflows in the short term (which they should be able to as long as deposit outflows remain below regulatory parameters for LCR) and not have a significant portion of their relationship deposits replaced with wholesale funding, then these banks should remain strong from a liquidity perspective and remain a going concern/solvent (assuming credit losses are manageable).
We also note that we are likely closer to the end of the interest rate hiking cycle, so we are likely seeing close to the top in deposit/wholesale funding cost, and as the liabilities typically have a shorter average life relative to assets, close to the end of incremental margin compression from the inverted yield curve, so the margin compression due to higher funding costs may be short-lived.
Table 16 – Margin Impact – First Republic Proforma Net Interest Margin
Table 17 – Margin Impact – PacWest Proforma Net Interest Margin
Table 18 – Margin Impact – Western Alliance Proforma Net Interest Margin
