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Peter Atwater: The Next Banking Crisis Is in Plain Sight


Banking capital won't cause the next crisis, but it's pretty obvious what will.

Bank analysts and banking regulators are funny people. They're always looking at the last banking crisis with the belief that history will repeat itself. If only they knew that's never the case. The worst lending in the last crisis is always the best in the next one, and the same goes for different parts of bank balance sheets. Where bank balance sheets take a blow to the bow, they reinforce them during the next recovery. For example, I've never seen such a focus on bank capital as I have over the past five years. Too bad that won't be where the next banking crisis rears its ugly head.

The next banking crisis -- whenever it comes -- will arise from the parts that fared the best in the last crisis. On the lending front, the problems ahead will be in commercial credit, automobile lending, student lending, and private banking lending. Those are where credit standards have been stretched the most during this recovery. Still, and probably most importantly, with regards to all of these lending sectors, the greatest risk-taking has taken place not in the banks but outside of the banks. When credit turns down, the lenders most impacted will be in the shadows -- asset managers, hedge funds, etc. -- not the banks. Of late, these lenders have been the biggest providers of credit to corporations -- and with unprecedented weak terms, too. The same can obviously be said for the federal government when it comes to student lending. Uncle Sam is the market.

My focus of this column, though, isn't credit. That's actually the least of my concerns about the banking industry right now. When the cycle turns, the banks will be the tail to much bigger and angrier lending dogs.

Where I'm most concerned about the banks today is in their funding. From my perspective, bank deposit books are a crisis waiting to happen. Over the weekend Lawrence C. Strauss offered a glowing profile on Regions Financial (NYSE:RF) in Barron's. In his story, he wrote, "The secret [to Region's uptick in net interest margin during the first quarter] is low funding costs. Some 90% of Regions deposits are considered low cost, meaning accounts where customers aren't locking up money for fixed, extended periods. Its average deposit cost is just 0.12%."

Thanks to a very protracted period of zero interest rates, Regions (along with just about every other American bank) has been converting its CDs and other time deposits to transaction accounts in an effort to preserve net interest margins. And the bank analysts have been encouraging this. Like Strauss, they've been delighted to see deposit costs come down.

What I think Strauss, the bank analyst community, and banking regulators have missed is that the banking industry is now mainly funded by hot money. For as much as 90% of the industry's deposits, there are no structural barriers to leaving. Deposits are completely liquid. They don't have a six-month, a one-month, or a two-week maturity, let alone an overnight one. Contractually, they're available now.

Even more, if Region's 12 bps deposit cost is indicative of how little the industry is now paying for deposits, no depositor is going to think twice about leaving in a crisis. There's absolutely no financial reason to stay. The risk-reward trade-off is at a record low for depositors, and as a result, the slightest bump could quickly move depositors to action.

Finally, and making matters even worse, many depositors today feel like they've been victimized by the banking industry. Savers have been brutally punished by the prolonged period of extremely low rates. To think that savers will somehow come to the rescue of the same bank that pays them 12 bps is almost laughable.

Taken together, it feels to me like the industry is very poorly positioned for when the tide of central bank liquidity turns.

To believe the industry, they've considered higher deposit costs in their asset-liability planning. From a net interest margin perspective, most banks today are well-positioned for higher interest rates. What I'm afraid they've failed to plan for, however, is a scenario in which deposit costs are rising (because depositors are requiring this) at the same time longer-dated Treasury rates are falling (because the economy is slowing). In this scenario, net interest margins could easily be compressed.

With bank loan-to-deposit ratios low, the industry would counter that concerns about transaction deposit risk is unwarranted. Banks have record investment portfolios today. In a pinch, those securities can be sold or repo'ed to cover deposits.

While in concept I'd agree with that, that scenario seems naive given current credit market dynamics. Not only do credit markets naturally dry up when the economy turns down, investment bank trading inventories are meager even now.  Between industry consolidation and changes to capital requirements, trading desks don't have much appetite to take on positions.

Then there's the question of what will happen to bond funds during the next credit downturn. Given how much risk now resides in bond funds -- at record high prices, too -- I don't think banks can depend on bond funds for liquidity. In fact, I can easily envision a scenario in which fixed-income asset managers and bank treasurers are both unloading securities at the same time to meet redemptions.

Needless to say, with the world awash in liquidity, I don't see anyone looking at this scenario -- and even those who are suggest that it's highly remote. Liquidity wasn't nearly as big of an issue in 2008 as capital. And with capital levels higher today than they were in 2007, liquidity won't be a problem in the future. If only people recognized how much the industry's higher capital ratios today are a function of loan loss-reserve releases and higher fixed-income asset prices.

Rather than celebrating banks' record low deposit costs, bank analysts, the media, and the banking regulators should focus on the downside to 90% transaction deposits. While I wish it weren't the case, rollover risk is the next banking crisis, and it's in plain sight.

Peter Atwater's groundbreaking book Moods and Markets is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -- Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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