Understanding Banking Deposits. Risks & Challenges.

11 May

Deposits in the Banking Industry

Bank Expansion

During periods of financial turmoil, large banks often expand their market share as their substantial balance sheets enable them to acquire struggling competitors and attract uninsured depositors seeking safety in their perceived too-big-to-fail status. This phenomenon was observed during the 2008 financial crisis and is happening again today, with America's largest bank, JPMorgan Chase, growing through both deposit inflows and the acquisition of a failed bank.

Deposit Concentration and the Federal Deposit Insurance Corporation (FDIC)

Bank deposits are essential for maintaining financial stability, as they supply banks with the necessary funds to lend to consumers and businesses. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) protects depositors by insuring up to $250,000 per depositor, per bank on various account types, including checking and savings accounts, Certificates of Deposits (CDs), and money market deposit accounts. This insurance is unconditionally backed by the full faith and credit of the US government.

During the 2008 crisis, emergency powers were used to stem deposit flows to mega banks. Targeted, temporary increases in deposit insurance caps were provided to help healthy regional and community banks retain their most valuable business accounts.

As of December 31, 2022, the FDIC's Deposit Insurance Fund held $128.2 billion. In addition to this fund, the FDIC has a line of credit from the US Treasury and can assess fees on the banking industry to replenish the Deposit Insurance Fund if necessary. The main worry with FDIC is that there are $7 trillion deposits currently above the $250,000 deposit per account cap. Universal coverage for all accounts is not a viable solution, as it could lead to reckless banks offering high yields to attract large depositors who would ignore risks, knowing that the FDIC would protect them. This could also distort capital flows away from money market funds and short-term Treasuries into bank deposits that offer quicker access to funds.

Transaction Account Guarantee (TAG) Program

During uncertain times, business account holders will consider transferring their accounts to a large bank deemed "too big to fail," even if their current bank is not experiencing any difficulties. To instill confidence in these account holders regarding the safety of their transaction accounts, the Transaction Account Guarantee (TAG) program was implemented during the 2008 crisis. This program offered unlimited coverage as account holders tended to maintain only the necessary balances for their operations. By protecting these accounts, it ensures that employers with uninsured deposits in a failed bank can still access the necessary funds for paying their employees and covering expenses. Moreover, TAG prevents a widespread concentration of deposits in the largest banks.

Congressional Action

While the Dodd-Frank Act now requires Congressional authorization for TAG, there is a fast track. During the Covid emergency, the Trump administration secured temporary reinstatement of the FDIC's TAG authority, which fortunately the FDIC never had to use. However, the Biden administration has not asked for a Congressional go-ahead and is instead working with regulators to implicitly guarantee uninsured accounts using special emergency powers unsuited to that purpose. Each time a bank fails, two-thirds majorities of both the FDIC and Federal Reserve Boards must approve the use of those powers, and it is highly questionable whether Republican appointees will keep providing votes to bail out the uninsured. To promote banking competition and mitigate concentrations of power, Congress needs to reinstate TAG and help regional and community banks protect their core business accounts. Although these banks have a target on their backs and perhaps deserve some comeuppance for their 2018 lobbying to weaken oversight, they play an important role in providing credit.

Bank Deposits and Financial Stability

Bank deposits are a crucial to financial stability, as they provide banks with the necessary funds to lend to businesses and consumers. When depositors withdraw their funds en masse, it can lead to a bank run, which can destabilize the entire financial system. A recent investigation revealed that the three largest banks in the US, JPMorgan Chase, Bank of America, and Wells Fargo, lost a combined $464.7 billion in deposits between April 27, 2022, and April 26, 2023. This represents 72% of the decline in deposits at the 25 largest banks. In contrast, the 4,000 small banks in the US lost a total of $210 billion in deposits during the same period. The Federal Reserve has issued a warning that the recent banking turmoil could lead to a broad credit crunch, which could slow down the US economy. The collapse of Silicon Valley Bank, Signature Bank, and First Republic has led to concerns about loan losses and deposit flight, causing lenders to tighten lending standards. The Fed's twice-yearly financial stability report highlights worries about the economic outlook, credit quality, and funding liquidity, which could lead banks and other financial institutions to further contract the supply of credit to the economy.

Deposits Overview

Deposits at banks can be broadly classified into two categories: demand deposits and time deposits. Demand deposits, also known as checking accounts, allow customers to withdraw their funds at any time without prior notice. Time deposits, on the other hand, require customers to commit their funds for a specified period, during which withdrawals are subject to penalties. Examples of time deposits include savings accounts, certificates of deposit (CDs), and fixed deposits.

Banking Deposits Risks

Credit Risk: Credit risk refers to the possibility that a borrower will default on their loan obligations, resulting in a loss for the bank. In the context of deposits, credit risk arises when banks use the deposited funds to extend loans and make investments. If a significant number of borrowers default on their loans, the bank may struggle to meet its obligations to depositors, potentially leading to a loss of confidence and a run on the bank.

Liquidity Risk: Liquidity risk is the risk that a bank will be unable to meet its short-term financial obligations due to a lack of readily available funds. Banks rely on deposits as a primary source of funding, but they also need to maintain a certain level of liquid assets (such as cash and government securities) to meet unexpected cash outflows. A bank may face liquidity risk if it experiences a sudden surge in withdrawals or if its investments become illiquid, making it difficult to convert them into cash quickly.

Interest Rate Risk: Interest rate risk refers to the potential impact of changes in market interest rates on a bank's profitability and financial stability. Banks earn interest income from loans and investments, while they pay interest on deposits. A rise in interest rates can increase the cost of deposits, while a decline in interest rates can reduce the interest income earned on loans and investments.

Operational Risk: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. In the context of deposits, operational risks can arise from various sources, such as errors in transaction processing, fraud, system failures, or natural disasters.

Regulatory Risk: Regulatory risk refers to the potential impact of changes in laws, regulations, and supervisory practices on a bank's operations and financial performance. Banks are subject to various regulatory requirements, such as capital adequacy, liquidity, and consumer protection rules. Changes in these regulations can affect the cost of deposits, the availability of funding, and the overall risk profile of a bank.

Short Selling and Its Impact on Bank Stocks

Short selling has recently contributed to the collapse of several US banks. Notably, Silvergate Bank and First Republic Bank suffered significant setbacks as short sellers took massive short positions in their stocks. Hedge funds capitalized on this situation, earning more than $7 billion by betting against bank shares, marking their largest gains since the 2008 financial crisis. Presently, PacWest Bancorp and Western Alliance Bancorporation are also targeted by short sellers. In response, PacWest's shares plummeted by up to 60% following reports of the bank considering strategic options, including a potential sale or fundraising round. Despite reassurances from Jerome Powell, Chair of the US Federal Reserve, that the country's banking system remains sound and resilient, smaller regional banks, responsible for nearly half of consumer and business lending, have suffered substantial losses due to short selling.

During the 2008 financial crisis, the Securities and Exchange Commission (SEC) halted short selling in 799 financial institutions. However, this time, no decisive action has been taken, raising concerns about the effectiveness of regulatory measures in tackling the ongoing crisis. The Federal Deposit Insurance Corporation (FDIC) cannot afford to let the situation escalate, as it poses a threat to national security. JPMorgan Chase's Jamie Dimon, has faced difficulties stabilizing the banking crisis, particularly as his bank plays a key role in financing hedge funds that contribute to the depreciation of bank stock prices through short selling.

As well, Dimon's track record raises doubts, exemplified by his involvement in the London Whale incident. This incident involved JPMorgan's derivative traders losing $6.2 billion of customers' deposits through trading risky derivatives. The US Senate's Permanent Subcommittee on Investigations revealed that top officials at JPMorgan allowed excessive losses to occur by repeatedly breaching the bank's risk limits within the Chief Investment Office. Furthermore, the Office of the Comptroller of the Currency, the bank's primary regulator, failed to take action despite red flags indicating the breach of risk limits by JPMorgan.

Lending Standards and Economic Outlook

The Fed also released the results of its quarterly Senior Loan Officer Opinion Survey, which found that banks expect to tighten lending standards in the rest of 2023. The largest banks blamed the potential lending slowdown on an uncertain economic outlook, while mid-sized and other banks more frequently cited concerns regarding their liquidity positions, deposit outflows, and funding costs as reasons for tightening. In a bid to retain depositors, some banks have had to offer better yields on savings accounts, weighing on profit margins.

Summing it all up

  • During financial turmoil, large banks can expand their market share by acquiring struggling competitors and attracting uninsured depositors seeking safety in their perceived too-big-to-fail status. This creates deposit concentration.

  • There are concerns about the $7 trillion in deposits currently above the FDIC insurance cap.

  • The Transaction Account Guarantee (TAG) program was implemented during the 2008 crisis to instill confidence in business account holders and prevent concentration of deposits in the largest banks. This program lifted the FDIC $250k cap.

  • Congressional action is needed to reinstate TAG.

  • Bank deposits are crucial for financial stability, but recent declines in deposits at large banks raise concerns about a potential credit crunch and contraction of credit supply to the economy.

  • Deposits can be classified into demand deposits and time deposits, and banks face risks such as credit risk, liquidity risk, interest rate risk, operational risk, and regulatory risk related to deposits.

  • Short selling has contributed to the collapse of several US banks, raising concerns about the effectiveness of regulatory measures in addressing the ongoing crisis.

  • Tightening lending standards are expected as banks cite an uncertain economic outlook, liquidity positions, deposit outflows, and funding costs as reasons for tightening.

For more analysis on these topics, check out these articles:

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