If you are worried about the recent bank failures in the US and wondering how it could affect you…you're not alone. Three regional banks have already failed in the last few months, and more are on high-risk alert. But what's causing these bank failures? And how can you protect yourself as a banking customer and an investor?
First, let's review the banks. Banks generate most of their revenue by investing or lending money to individuals or businesses based on the amount of deposits they receive from their bank customers. The spread between the interest they owe on their deposits and the interest they earn investing or lending is known as “net interest income.” The banks can invest because they assume that not every bank customer will request to withdraw all of their cash at once. The greater the spread, the larger the revenue. Banks keep enough liquidity to balance their investments with their customers’ estimated immediate liquidity needs. If they get into a pinch, they can temporarily borrow from other banks (known as interbank lending) or the Federal Reserve (discount window lending) until they can raise the cash their banking clients need.
Typically, banks are very good at this balancing act. But in the aftermath of Covid-19, the fiscal and monetary responses led to an extraordinary surge in the money supply. M1 is the economic figure that tracks the amount of money in circulation and held in bank deposits (see chart below). In fact, M1 increased fivefold between 2020 and 2021. Interest rates were cut to 0%, and trillions of dollars were dispersed through stimulus checks, tax breaks, free loans, and other low credit-inducing measures. As a result, bank deposits skyrocketed. And of course, the banks needed to put all that cash to work in order to earn a profit. Many banks invested in the safest and most secure investments they could think of – U.S. treasury bonds. Unfortunately, those bonds only paid 1-2% at the time, with maturities that were ten to thirty years in the future. Of course, bonds can be sold before maturity on the open markets. But the price they can sell the bonds for is primarily driven by new bond offerings available. If new bonds are paying 4% and your bonds are paying 1%, you will have to sell the bonds for a price that is significantly discounted to make it as attractive as the newly issued, higher-paying bonds available today.
Now an economics lesson:
Econ 101 - An increase in the money supply that outpaces the increase in the output of goods and services leads to high inflation.
In other words, more money chasing a limited number of goods and services will increase prices. And as we are all well aware, that is exactly what has happened ever since our money supply (M1) increased dramatically. Of course, the Fed had to respond aggressively by raising interest rates swiftly. With increasing rates, new treasury bond offerings started paying 4-5%, making the bonds issued in 2020 and 2021 at lower rates much less attractive. Many of the bonds issued and purchased by the banks in 2020-21 have since decreased their values by as much as 40-50% if sold at current prices. Not an ideal situation for an industry that can have its assets requested and moved with one click of a customer’s iPhone.
According to Bloomberg, it is estimated that over $620 billion in bond losses were on banks’ balance sheets at the end of 2022. While larger banks can absorb this temporary loss and have other means of liquidity, smaller/regional banks may not be so fortunate. Early concerns over the bond losses (as well as other high-risk investment losses for some of the banks) spread over social media, and many bank customers started pulling their money out, further escalating the liquidity problem. This is what is known as a classic “bank run.”
Thankfully, the United States Treasury has stepped in to protect the uninsured amounts over the FDIC limits for the three failed banks to ensure that all their bank customers were made whole, even if their deposits exceed the normal FDIC limits of $250,000 per account registration. However, many bank customers are still making moves and shifting cash around to protect themselves, and FDIC limits have yet to be increased. So consumers should not be complacent with their cash, especially if they run a small business and keep high cash balances.
You may be wondering what you can do to safeguard your money. One option is to diversify your deposits among several banks, each with FDIC insurance coverage, to ensure you are fully covered. You can also utilize money market funds backed by treasuries (Ranch Cap’s preference) or even buy one-month treasuries on your own. Heck, even Apple announced they are offering a high-yield savings account (around 4.15%) with FDIC insurance up to $250,000. These days it is easy to work with multiple financial institutes and manage your cash all from your phone. Don't just settle for convenience. Banks will need to increase their rates to hold on to their customers or risk more bank runs. Apple brought in almost $1 billion dollars in the first four days, so banks had better get with it.
M1 money supply (Not a Tesla chart)
Gregg Pacitti CFP®