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Institute Alert: Regulators coordinate support to the banking system

Wells Fargo Investment Institute - March 13, 2023

by Paul Christopher, CFA, Head of Global Investment Strategy

Key takeaways

  • A joint statement released on March 12 by the Federal Deposit Insurance Corporation (FDIC), the U.S. Treasury, and the Federal Reserve (Fed) announced measures to protect depositors at banks that failed within the past week, and to provide support to the banking system.
  • We view these measures as strong positives, insofar as there may be other banks that have duration (a measure of a bond’s interest rate sensitivity) mismatches in their balance sheets.

What it may mean for investors

  • The economy is slowing, liquidity is becoming more limited in the banking sector, and we still expect short-term interest rates to rise further. Consequently, we continue to favor defensive portfolio positioning, as we laid out in our report of March 12.

A joint statement released on Sunday by the FDIC, the U.S. Treasury, and the Fed announced that depositors in two failed banks will be made whole and will have full access to their deposits beginning March 13. The move should shore up confidence and block spillover effects after California regulators closed a bank on Friday and the New York state chartering agency did the same for a small bank in New York City on Sunday.

According to the plan, taxpayers will bear none of the losses. Instead, a $100-billion fund that banks pay into regularly will backstop the depositor protection. Regulators also have removed senior management at these two banks. Any losses to the FDIC to support uninsured depositors will be replaced by a special assessment on banks, according to law.

To reinforce confidence in the system, the same joint statement announced that the Federal Reserve Board will provide additional funding to banks to help ensure that they can meet the needs of depositors. The new program, which the Fed calls the “Bank Term Funding Program,” will offer loans to any bank under easier terms than are available at the Fed’s usual funding mechanism, known as the discount window.

Typically, banks can borrow from the Fed by pledging securities, and the Fed lends a fraction of the collateral’s market value. In this new program, the Fed will accept U.S. Treasuries and other high-quality securities, and a bank can borrow for one year at up to the full collateral value and at an attractive rate. According to Bloomberg, Fed officials on a conference call on Sunday noted that the program will be large enough to protect deposits not already covered by the FDIC. For banks that cannot repay after one year, the Treasury will make available up to $25 billion from its Exchange Stabilization Fund, as an additional backstop.

Our perspective

As we explained in our report of March 12, deposit flows into banks were strong over the 2019-2021 period. Some banks have not managed their mix of assets and liabilities well and have developed excessively large exposures to long-dated U.S. Treasuries or mortgage-backed securities — all long-duration assets whose values have declined on paper since interest rates have risen. Higher interest rates have another effect. As depositors come in looking to transfer their funds to higher-paying money market rates, some banks must sell their long-duration assets to raise cash for depositor withdrawals. These sales recognize losses that previously had only been on paper. Some banks will be obliged to write-down capital, and the latest bank failure on March 12 raises the potential that other banks may have some of the same problems.

We believe the banking system as a whole has a more diversified balance sheet and should be much less vulnerable to rising interest rates than the failed banks. However, the risk of some additional failures could weaken confidence in the banking system and cause a disproportionately large public concern. These steps by the banking regulators address that concern directly. 

Still, as we laid out in our March 12 report, we continue to favor defensive positioning in portfolios. The economy is slowing, and Fed policy makers likely will continue to hike rates in smaller increments. We expect a quarter-point (0.25%) hike at the March 21-22 meeting.

Looking beyond the next meeting, we believe the Fed has a narrower path to walk. Rate hikes are a big part of the Fed’s anti-inflation strategy. Yet, the large spread between short-term rates, which the Fed controls, and longer-term rates likely will have bank depositors considering all options available for their liquid capital. As liquidity in the banking system continues to decline, banks are likely to have less cash available to lend. This prospect reinforces our expectation that the economy will slow further. 

Download the report (PDF)