Small and regional U.S. banks have survived the collapse of Signature and Silicon Valley banks and their stock values have largely stabilized—only to face a future of tighter regulations, lower stock values, and demands from depositors for higher interest rates, Wall Street Journal analyst James Mackintosh wrote in a 14 June essay.

Banks’ problems stem from a perfect storm of events, Mackintosh noted.

First, the Fed slashed interest rates to almost zero early in the COVID War. Banks were flooded with cash as people were locked down at home and had lost an array of opportunities to spend.

Banks had to do something safe with all that cash so they parked it in government securities, the same ones paying almost nothing in interest.

Second, the Fed began steadily raising its rates 14 months ago. New issues of government bonds paid more than bank deposits. Money market funds typically invest heavily in short-term government bonds.

As a result, the funds could pay depositors as much as 4 percent interest, while banks’ returns were averaging 0.4 percent in May. 

“You could get 5 percent or more from an online-only account, t-bills, or a money market fund, but the bank is exploiting your loyalty or laziness,” Mackintosh said.

Now, to hang onto deposits, banks are being forced to raise the rates they pay, cutting into their margins.

At the same time, banks are unable to sell those low-interest bonds to protect those margins; newer bonds pay better yields, so investors are pocketing those instead.

Third, the yield curve has flipped.

Banks used to be able to borrow from the Fed short-term and pay negligible interest. Now, however, short-term interest rates are higher than those for longer-term government bonds.

In May, “the yield on the 10-year Treasury was the furthest below the Fed’s target rate since 1989,” Mackintosh noted. “This simple model of what’s known as maturity transformation now makes a loss, not a profit.”

In addition to the Fed’s triple whammy, banks have to hold more cash—by choice or regulation—as a stumbling economy raises the likelihood that more loans will fail. Banks will need the extra cash to cover those losses.

“This doesn’t mean banks are all doomed,” Mackintosh added, “but does mean—especially if the yield curve stays inverted—that more banks could fall over. It also means that banks will be constrained by more watchful government overseers.”

The reason: banks now hold assets worth at least $2 trillion less than they paid for those assets because of the Fed’s higher interest rates, according to a March analysis by a group of university economists.

TREND FORECAST: Regulators are keeping a closer eye on banks, as we note in “Bank Regulators Express Concern Over Real Estate Risk” in this issue.

Because of that, fewer banks will fail. However, more banks will be forced to dump assets at a loss. Those that are thinly capitalized to begin with will, willingly or not, become takeover targets.