Crisis Induced Deposit Flight Could Reshape Regional Banks

• We expect the events of the last two weeks will lead to higher funding costs, more conservative balance sheet management to shore up liquidity and tighter lending standards, which will negatively impact profitability for many banks and reduce their ability to provide credit to clients.
• We believe stricter regulations will follow in the aftermath of the crisis but, for now, regulators are concentrating on increasing confidence in the banking system in an effort to stabilize deposit flows.
• While the future is less certain for regional banks with high levels of uninsured deposits and/or a focus on the innovation economy, global systemically important banks (G-SIBs) and super regionals are poised to be the winners of a potential redistribution of deposits due to larger footprints, strong brands and balance sheets and more diversified client bases.

The failure of Silicon Valley Bank (SIVB) and Signature Bank (SBNY) has increased concerns of potential deposit outflows across the banking system, leading investors to scrutinize banks that may face similar issues. Amidst the crisis, stakeholders and the media chose to focus on banks with large, unrealized investment security losses and a higher mix of uninsured deposits on the notion that they are more susceptible to deposit outflows, triggering losses and impacting regulatory capital. This has sparked a flight to safety among some bank clients, resulting in a shift in relationships and deposits toward larger, more diversified banks subject to increased regulatory oversight, affording them the perception of safety.

We expect the events of the last two weeks will lead to higher funding costs, more conservative balance sheet management to shore up liquidity and tighter lending standards. We expect stricter regulations to follow in the aftermath of the crisis but, for now, regulators are concentrating on increasing confidence in the banking system in an effort to stabilize deposit flows.

For banks that experienced substantial deposit outflows, such as First Republic Bank (FRC), the damage to earnings power may be significant and could take years to recover. The $30 billion in new deposits to FRC, provided by a consortium of large U.S. banks, may ultimately not prove sufficient to slow outflows to the level where the bank can maintain adequate levels of profitability to remain a stand-alone entity. The banking industry more broadly has taken steps to raise cash through short-term borrowing to meet potential deposit withdrawals and will likely slow loan growth to further improve their liquidity profile. These actions come at a cost and will reduce profitability. Banks will look to recoup some of these profits by demanding higher loan spreads which, when coupled with tightening underwriting standards, will reduce credit availability. While private credit will absorb some of the shortfall, a sizable shift in lending to unregulated markets poses its own risks to the financial system.

We believe that much of the deposit migration has found its way to the nation’s largest banks or into short-term investments such as money market funds and Treasurys. It is still early days, but the outsized deposit outflows appear to have been short-lived and isolated to banks with heavy client and/or geographic concentrations. Initial reports appear to show that G-SIBs, such as Bank of America, have been the recipients of these deposit inflows since the start of the banking crisis, but we believe the priority for G-SIBs and regulators alike is to restore confidence in the banking system and prevent additional bank runs as the industry will bear the cost of future bank failures through higher deposit insurance premiums. While G-SIBs such as JP Morgan Chase (JPM) played a role in acquiring failed institutions during the Global Financial Crisis (GFC), it is unlikely to participate in acquisitions of failed banks this time given high unexpected costs resulting from litigation and fines levied by regulators for the actions undertaken by the troubled banks prior to JPM’s involvement.

While G-SIBs have been the beneficiaries of the initial redistribution of deposits, regulatory and collateral requirements limit the value of deposits banks can accept given the capital needed to support growth. Large banks are governed by liquidity coverage ratios (LCR), and must hold sufficient high-quality, liquid assets to withstand significant deposit outflows. Over the longer term, we see regulators revisiting their underlying assumptions for LCR given the unprecedented deposit outflows that certain banks experienced in a matter of days.

Beyond the G-SIBs, we believe that Category III banks such as U.S. Bancorp and PNC Financial, which have total assets between $250 billion and $700 billion, are also seeing deposit inflows. These “near-G-SIBs” could prove relative winners among the regional banks in a redistribution of deposits due to their larger footprint, strong brands/reputations and diversified client bases. Additionally, they are already subject to stricter regulations than smaller banks and have sufficient scale to better navigate a tougher regulatory environment.

In response to the current crisis, we anticipate greater supervision around LCR, interest-rate sensitivity and increased capital requirements for all banks, likely to be incremental for the largest banks but more meaningful for smaller banks down to the $100 billion asset threshold. We expect the higher regulatory burden will be a drag on profitability and will be passed through to customers through higher prices/fees (and possibly lower rates on some deposits). However, there are some positives to increased regulation, including greater confidence that banks can better manage future liquidity crises, similar to how the post-GFC regulatory environment provided greater comfort in banks’ ability to withstand credit stress.

Super regionals are in a better position to participate in industry consolidation as they have plenty of runway to grow deposits before hitting regulatory limits. Despite years of M&A activity at the local and community bank levels, the U.S. banking industry remains highly fragmented compared to other developed markets.

Exhibit 1: Reliance on Uninsured Deposits Varies Across Banking System

The road ahead is less certain for FRC and other regional banks with characteristics like SIVB and SBNY, including a largely fixed-rate asset base, a high proportion of uninsured deposits and/or exposure to clients in the innovation economy, which have been the source of outsized deposit withdrawals. The regional bank business model is under scrutiny as SIVB exposed the risks of mismanaging interest rate exposure by investing in long-duration assets despite having a concentration of venture-backed clients with near-term cash needs (making deposit durations short). Should fears of contagion re-emerge, small- and mid-size regionals could lose further deposit market share and face higher funding costs, crimping their ability to lend and leading to structurally lower profitability. Rating agencies placing banks on review could also worsen the issues facing banks with similar profiles to SIVB and SBNY.

While we have moved to the sidelines on some of the smaller regional banks in the near term, we maintain exposure to select banks and continue to monitor the crisis. Risks undoubtedly remain, but we have seen signs of stabilization. We are analyzing the events as they unfold and will adjust our exposure to these stocks accordingly.

Confidence that the crisis has been contained and evidence that deposit outflows have stabilized or reversed are crucial for improving sentiment from investors and clients alike. The deposit panic appears to be subsiding with regulators communicating, both through actions and words, their commitment to the safety and soundness of the banking system. To the degree the negative feedback loop that exacerbated the crisis is curtailed, regional banks and smaller asset-based lenders can lean on the relationship-based lending that is the foundation of their model to once again attract new business.

We see community banks as better insulated from the redistribution of deposits impacting some regionals, as these lenders have little competition in their local markets and a more granular deposit base.