Zacks Investment Management

Chase K. from Reno, NV asks: Hello Mitch, I’m sure many of your readers are worried that the banking crisis could unravel into a full-on financial crisis, akin to what we saw in 2008. Most of the commentary I’ve read says that the likelihood of a recession has now gone way up, which makes the whole situation feel like a ticking time bomb. Would love to hear your thoughts, thank you.

Mitch’s Response:

Thanks for writing. There are two questions here, the first regarding the possibility of a financial crisis and the second regarding the economic recession. I’ll break my response up into two parts.

The first part is regarding a full-on financial crisis, which I see as a very unlikely possibility. The Silicon Valley Bank (SIVB) and Signature Bank New York (SBNY) failures have been billed as the second and third-largest bank failures ever, but that’s a misleading characterization, in my view. When you scale the size of the bank failures relative to the U.S. GDP and adjust for inflation, you find that other bank failures in history were much bigger.¹

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The other important characteristic of these two bank failures is that both banks were in unique risk positions, with SIVB catering to VC/tech clients and Signature Bank having 20% of its depositors in the cryptocurrency industry – both of which suffered greatly in 2022. By the end of last year, both banks had 90+% of deposits uninsured, and neither had taken any steps to manage interest rate risk on their fixed-rate investment securities on balance sheets. Both banks were largely in a league of their own.

Looking outside of these failures in the broad U.S. banking system, I do not think it is an exaggeration to state that the system is extremely well-capitalized. Tier 1 capital ratios are well above average (see chart below), and loan-to-deposit ratios are at their lowest levels in 50+ years. By our assessment, almost every major bank can meet withdrawal requests without having to make sales in their fixed-rate securities portfolios, which has become even more apparent as deposits have flowed from regional banks to larger ones. In short, while confidence in regional banks remains tenuous, and could result in more volatility in that space and perhaps even more failures, I think the risk of a broader financial contagion is very, very low.

Tier 1 Bank Capital as a % of Risk Assets

The recession question is an interesting one. In the wake of the regional bank crisis, there have been more calls for regulation, which I think could drive some uncertainty in the markets and also arguably put more banks into ‘risk averse’ mode. Smaller banks may also respond to this environment by deciding that a dollar in reserves is better than a dollar leant, which could reverberate into a slowdown in loan activity. The 25 biggest banks account for approximately 60% of all outstanding loans, which of course means smaller banks make up the remaining 40%. Smaller banks also account for 67% of commercial real estate lending, according to the Federal Reserve, which could mean capital for new projects could be restrained.⁴

On the other hand, the jobs market remains strong today, and the impact of higher rates on banks’ investment securities portfolios is putting future rate hikes into question. My guess is that the Fed will be thinking hard about a ‘pause’ perhaps sooner than expected, which would lower the possibility of overtightening and triggering a recession in the process. My general view here is that the fresh wave of pessimism that has come from the SIVB and SBNY failures has pretty dramatically set up the U.S. economy to surprise to the upside since just about everyone is recalibrating their expectations for recession.

During this time of uncertainty, I would suggest that investors avoid the urge to give in to market timing. Instead, focus on the long-term view and stick to your course!
 
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Disclosure